LIBOR stands for London Interbank Offered Rate and SOFR stands for Secured Overnight Financing Rate.
LIBOR
LIBOR is a benchmark interest rate that major global banks use to lend to each other in the interbank market for short-term loans. It is an index used to set the cost of variable-rate loans. This is an important metric when calculating loans payments with a floating interest rate that uses LIBOR.
Lenders will use the index to adjust interest rates as economic conditions change. Typically, the lender will add a fixed percentage over LIBOR (the margin); however, if LIBOR goes up then the overall interest rate on your loan would go up, thus increasing your payment.
When a loan is financed with a floating rate that is tied to LIBOR, the interest rate is determined like so:
The amount you will pay on your floating rate loan with LIBOR will be locked in at the beginning of the pay period. If you take that LIBOR rate and add the lender’s margin, you have your interest rate for that period.
Example: You secure a floating-rate loan for LIBOR plus 3% or 300 basis points. The 3% is a fixed rate that the lender charges over LIBOR. So, if LIBOR is 0.09% then the interest rate for that period would be 3% + 0.09% = 3.09%.
SOFR
SOFR is a benchmark interest rate, much like LIBOR, for dollar-denominated derivatives and loans. It is set to replace LIBOR soon. In 2017, the Federal Reserve set up the Alternative Reference Rate Committee that was made up of several large banks to select an alternative rate to LIBOR for the United States. The committee chose SOFR, an overnight rate, as the new benchmark for dollar-denominated contracts.
Like a floating-rate loan using LIBOR, SOFR would be used instead for the adjustable-rate. The lender will still charge a fixed rate over SOFR and the variation in your interest rate would be determined by SOFR calculated like so:
This is different from LIBOR because it takes the average rate over a certain period. The amount of interest charged would be the lenders fixed cost or margin plus SOFR for that period.
Example: You have an adjustable-rate loan that is SOFR plus 3% or 300 basis points. SOFR has averaged around 0.05% for the last month so your rate for this period would be 3% + 0.05% = 3.05%.
Conclusion
While there is not a huge disparity between LIBOR and SOFR rates today, I think it is important to at least be aware of how your adjustable-rate loan payment is calculated. It is also important to know about floating-rates because they can be beneficial over fixed-rate loans when buying and selling apartment complexes.
