What Is SOFR? How the Secured Overnight Financing Rate Works

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The Secured Overnight Financing Rate (SOFR) is a benchmark interest rate that measures the cost of borrowing U.S. dollars overnight when the loan is collateralized by U.S. Treasury securities. The Federal Reserve Bank of New York publishes it every business day. The rate comes from actual transactions in the Treasury repurchase (repo) market, not from bank estimates. SOFR replaced LIBOR as the main reference rate for dollar-denominated loans, bonds and derivatives, and LIBOR’s U.S. dollar settings stopped on June 30, 2023.

How SOFR Works

The underlying market

In a repo, one party sells Treasury securities to another and agrees to buy them back the next day at a slightly higher price. The price difference is the interest, and the securities protect the cash lender if the borrower fails to repay. SOFR covers three segments of this market: tri-party repo, General Collateral Finance (GCF) repo, and bilateral Treasury repo cleared through the Fixed Income Clearing Corporation. Their very large daily volume means the benchmark rests on deep, observable activity.

Calculating SOFR

The New York Fed collects the eligible trades from a business day, ranks them by rate, and finds the rate at which half of the dollar volume traded higher and half traded lower. This is a volume-weighted median. Large trades carry more weight than small ones, and a few unusual trades at the extremes cannot pull the result far. The rate for each business day is published the following morning.

Hypothetical example (illustration only): suppose a day had just four trades.

Total volume is $700 billion, so the median falls at the $350 billion mark. Ranked by rate, trades A and B cover the first $400 billion, so the volume-weighted median is 4.30%. A simple average of the four rates would give 4.31%, and trade D’s outlier rate would have more influence than its small size justifies.

Why it is called a secured, nearly risk-free rate

LIBOR measured what it cost a bank to borrow from other banks without collateral, so it carried each bank’s credit risk. SOFR measures the cost of borrowing against Treasuries, which are backed by the U.S. government, so a cash lender in a Treasury repo faces very little default risk. “Nearly risk-free” means the rate holds almost no credit premium. It does not mean the rate stays stable or that a loan priced off it carries no risk to the borrower.

From LIBOR to SOFR

In the U.S., the Adjustable Interest Rate (LIBOR) Act of 2022 gave a statutory fallback for older contracts that had no workable replacement clause. Under that framework, the affected contracts moved to a SOFR-based rate.

SOFR vs. LIBOR

Overnight SOFR, Averages, Index and Term SOFR

Overnight SOFR is a one-day rate, but most loans reset monthly or quarterly. Markets use four forms of it:

• Daily SOFR: the published overnight rate. Some loans apply it day by day.
• SOFR averages: 30-, 90- and 180-day compounded averages published by the New York Fed. A “30-day SOFR” rate usually means this backward-looking average. It smooths out daily swings.
• SOFR Index: a running measure of cumulative compounding since April 2018. With it, a user can work out compounded SOFR between any two dates by dividing the ending index value by the starting value.
• Term SOFR: forward-looking 1-, 3-, 6- and 12-month rates derived from SOFR futures and published by CME Group. “1-month SOFR” and “3-month SOFR” in loan agreements usually refer to these. Because the rate is known at the start of the period, borrowers can see each payment in advance, as they could under LIBOR.

The SOFR forward curve (often just called the SOFR curve) plots the rates that futures and swaps imply for future periods. It shows what the market is pricing for SOFR, not a forecast anyone guarantees.

How SOFR Is Used

• Business and commercial real estate loans are often quoted as term SOFR plus a fixed spread, such as “SOFR + 200 bps” (2 percentage points). The agreement specifies which SOFR version applies (term, daily or average), the reset dates, the day count and any floor, and those terms decide the actual interest owed.
• Adjustable-rate mortgages and student loans that once referenced LIBOR now commonly use SOFR averages.
• Floating-rate notes and asset-backed securities pay coupons tied to compounded SOFR.
• Derivatives are where SOFR plays its largest role. SOFR futures let traders hedge or bet on the average rate over future months. In SOFR interest rate swaps, one party pays a fixed rate and receives floating SOFR. The quoted fixed rates on these swaps are the “SOFR swap rates” that banks use to price fixed-rate loans and hedges.

Example: A SOFR Loan with a Swap

Hypothetical: a company borrows $50 million for three years at 3-month term SOFR + 2.25%, with quarterly resets. For simplicity, each quarter’s interest is calculated as principal × annual rate ÷ 4. Actual loan agreements usually apply an actual/360 day count, which produces slightly different figures.

The spread stays fixed and only the SOFR component moves. To cap its exposure, the company enters a swap where it pays a fixed 4.00% and receives 3-month term SOFR on the same $50 million. Its net cost becomes 4.00% + 2.25% = 6.25% each quarter. When term SOFR resets above 4.00%, the swap payments it receives offset part of the loan interest. When SOFR resets below 4.00%, the company pays more on the swap than it saves on the loan.

What Makes SOFR Change

SOFR closely tracks Federal Reserve policy. When the Fed raises or lowers its target range for the federal funds rate, repo rates move with it, often within days. Inflation matters through that channel: higher inflation tends to keep policy rates, and therefore SOFR, elevated. Supply and demand in the repo market also affect the rate. Heavy Treasury issuance, tax dates, falling bank reserves and quarter-end balance sheet constraints can push SOFR up temporarily. In September 2019, a cash shortage drove SOFR sharply above the Fed’s target range for a short time, and the Fed responded by injecting liquidity.

Limitations of SOFR

• No credit component. In a crisis, banks’ own funding costs can rise while SOFR falls, because investors move into Treasuries. A lender funding a SOFR loan can be squeezed in that situation.
• Spread adjustments were needed. LIBOR contracts that switched to SOFR added a fixed credit spread adjustment to bridge the gap. Under the ISDA fallback terms these adjustments are about 11.448 basis points for 1-month LIBOR and 26.161 basis points for 3-month LIBOR.
• Overnight and backward-looking at its core. Term rates depend on a futures market built on top of SOFR, and compounded averages are known only at the end of the period.
• Short-term spikes. Month-end and quarter-end pressures can move the daily rate more than borrowers expect, which is why averages exist.

SOFR vs. Rates It Gets Confused With

• Federal funds rate: the effective fed funds rate measures unsecured overnight lending between banks. SOFR measures secured Treasury repo. The two usually trade close together but are separate rates.
• Treasury yields: a 5-year Treasury yield reflects five years of expected rates plus a term premium on a bond. SOFR is an overnight funding rate. Comparing them means comparing different maturities.
• Prime rate: a rate banks set for lending to customers, usually tied to the fed funds target. It is not a market-derived benchmark.
• SONIA: the U.K. equivalent is the Sterling Overnight Index Average. It is unsecured and administered by the Bank of England, so sterling bonds reference SONIA rather than SOFR.

The Bottom Line

SOFR matters to anyone with a floating-rate business loan, adjustable-rate mortgage, student loan, floating-rate note or swap. Borrowers should check which SOFR version their agreement uses, along with reset dates, day count and any floor, since those terms set the interest owed. A borrower who wants predictable payments can use a swap to lock in a fixed cost, accepting that the swap costs more when SOFR falls.