Transitioning from LIBOR to SOFRDecember 4, 2020
When you take out a student loan, you’ll receive an interest rate. The interest you pay is essentially an additional fee for borrowing the money. The interest rate you’ll receive from a loan provider is a benchmark standard rate plus any additional margin set by the lender. The additional margin is based on your credit history and score, among other factors. The better your credit history, the lower the margin, and the less interest you will pay.
Previously, the benchmark rate lenders used to set interest rates was LIBOR, or the London Interbank Offered Rate. LIBOR is the estimated rate at which international banks lend to each other for short-term loans. LIBOR, however, is being phased out through 2021 due to accuracy concerns.
Originally, the LIBOR rate was based on estimates for the types of transactions that occurred often. Now, however, those types of transactions are less frequent, so it’s more difficult to ascertain the most accurate rate. Beginning in 2021, the new rate will be the Secured Overnight Financing Rate, or SOFR.
SOFR is a benchmark interest rate based on the overnight borrowing costs of banks. The rate is determined based on the previous night’s activity of the Treasury repurchase market.
SOFR v. LIBOR
Now that you understand the reason for the transition from LIBOR to SOFR, let’s look at the differences between the two.
Actual v. Estimate
LIBOR rates are estimates of the rate for borrowing and thus are not based on the costs of actual transactions. London-based banks submit estimates of the interest rates that other banks charge them, then calculate the average to determine the LIBOR rate. The SOFR is based on actual transactions, so it may be more reliable.
SOFR is simply a daily rate since it is calculated every day based on overnight data. LIBOR has seven different terms, with rates changing at varying frequencies.
Many experts believe that SOFR is lower-risk because the model is based on actual transactions using Treasuries. LIBOR has more inherent risk because it is based on estimates rather than real transactions.
LIBOR and SOFR are not the only rate models. Many different interest rate models are used around the world.
- SONIA – Sterling Overnight Index Average (SONIA) is the benchmark published by the Bank of England. This rate is based on the average of the overnight interest rates of unsecured transactions.
- Eonia – Euro Overnight Index Average (Eonia) is the overnight interest rate that banks lend to one another in Euros. This model will be phased out by 2022 and replaced with ESTER.
- ESTER – Euro Short Term Rate (ESTER) is an overnight interest rate of the average of wholesale rates in Europe. It will average more banks than Eonia and therefore is supposed to be a more accurate representation of interest rates.
- Euribor – the Euro Interbank Offer Rate is a daily rate based on the average interest rates that banks in the European Union offer to other banks for unsecured funds.
- EIBOR – the Emirates Interbank Offered Rate is the benchmark interest rate used by banks in the United Arab Emirates (UAE). It is a daily rate based on the averages of interest rates used by banks lending to one another in the UAE.
How Does The Transition From LIBOR to SOFR Affect You?
If you have a variable interest rate on a private student loan and your loan contract references the LIBOR rate, you should pay attention to your loan to monitor whether the interest rate has changed. If you find yourself with a higher interest rate after the LIBOR to SOFR transition, you may want to consider refinancing your student loans.
Student loan refinancing enables you to receive a new, and often lower, interest rate based on your credit score, credit history and employment. When you refinance with a reputable student lender, you can choose a loan with a fixed interest rate instead of a variable rate if you do not want to be subject to interest rate changes.
It’s important to check with your lender about how the LIBOR to SOFR transition may affect your student loans. Then you will be able to make an informed decision regarding your loans once the transition is complete.