SOFR (Secured Overnight Financing Rate)

The Secured Overnight Financing Rate (SOFR) is a benchmark interest rate that represents the cost of borrowing cash overnight using U.S. Treasury securities as collateral. It is based on actual transactions in the repurchase agreement (repo) market, where borrowers secure short-term loans with collateral, making it a reliable indicator of the cost of money in the short term. For example, if a financial institution borrows $1 million overnight at a SOFR of 0.05%, it will pay $500 in interest for that day.

One common misconception is that SOFR is a fixed rate, but in reality, it fluctuates daily based on market conditions. As of October 2023, SOFR has been observed to range from 0.01% to 5.50% over recent months. This variability means that borrowers should stay informed about current rates to anticipate interest costs on loans tied to SOFR, such as adjustable-rate mortgages or corporate loans.

SOFR also plays a significant role in the transition away from LIBOR (London Interbank Offered Rate), which has been phased out due to manipulation scandals. Financial instruments like derivatives and bonds are increasingly linked to SOFR, making it essential for investors and borrowers alike to understand its implications. For instance, if a company issues a $10 million bond with a coupon rate set at SOFR + 2%, any changes in SOFR will directly affect the interest payments the company must make, impacting its cash flow.

The key takeaway is that understanding SOFR can help individuals and businesses manage their financial decisions more effectively. Always check the latest SOFR rates when considering loans or investments that reference this benchmark to make informed financial choices.