Every floating-rate commercial loan issued in the United States today is tied to SOFR. Every interest rate cap written to protect those loans is priced against it, settles against it, and lives or dies by it. Yet most borrowers who buy rate caps have only a surface-level understanding of what SOFR actually is, how it moves, and why it drives both the cost of their cap and the size of any settlements they receive. This guide changes that.
In This Guide
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What SOFR Actually Is
SOFR stands for the Secured Overnight Financing Rate. It is a daily benchmark interest rate published each morning by the Federal Reserve Bank of New York at approximately 8:00 a.m. Eastern Time. Despite its technical-sounding name, the concept behind it is straightforward: SOFR measures the average rate at which large financial institutions borrowed cash overnight by pledging U.S. Treasury securities as collateral.
Those overnight borrowing transactions take place in the U.S. Treasury repurchase agreement market — the “repo” market. In a repo transaction, a financial institution sells Treasury securities to a lender and simultaneously agrees to buy them back the following day at a slightly higher price. The difference between the sale price and the repurchase price represents the cost of borrowing — the overnight interest rate. SOFR is calculated as a volume-weighted median of all such transactions observed on the previous business day, with daily transaction volumes typically running in the trillions of dollars.
Daily repo transaction volume underlying SOFR calculation on a typical business day
Time each morning when the NY Fed publishes the prior day’s SOFR rate
Date when LIBOR was fully discontinued and SOFR became the exclusive benchmark for new U.S. dollar contracts
Why the “secured” part matters
The word “secured” in SOFR’s name is meaningful. Because the overnight lending it measures is backed by U.S. Treasury collateral — considered the highest-quality, lowest-risk collateral available — SOFR is a nearly risk-free rate. The lender in a repo transaction faces almost no credit risk because they hold Treasury securities as security for the loan. This is fundamentally different from LIBOR, which measured unsecured lending between banks and therefore incorporated a bank credit risk premium above the risk-free rate.
The practical implication for borrowers is that SOFR trades at or very close to the Federal Reserve’s policy rate, without the bank credit spread that LIBOR carried. When comparing SOFR levels to historical LIBOR levels, it is important to account for this difference — SOFR will typically be slightly lower than LIBOR would have been under the same monetary conditions, which is why the ARRC recommended a spread adjustment of approximately 26 basis points when converting 3-month LIBOR contracts to SOFR during the transition.
How SOFR Replaced LIBOR: The Transition That Changed Everything
Understanding why LIBOR was replaced — and why that replacement matters for your rate cap — requires a brief look at what went wrong with the old benchmark and how the transition was managed.
The London Interbank Offered Rate is established as a benchmark for the cost of unsecured interbank borrowing. It quickly becomes the global standard reference rate for floating-rate loans, derivatives, and financial products denominated in multiple currencies.
Investigations reveal that traders at multiple major banks had been manipulating LIBOR submissions to benefit their derivatives positions. Billions in fines are levied. The revelation exposes a structural flaw: LIBOR was based on bank estimates, not actual transactions, creating both the opportunity and the incentive for manipulation.
The UK Financial Conduct Authority announces it will no longer compel banks to submit LIBOR quotes after 2021. The ARRC (Alternative Reference Rates Committee) in the U.S. selects SOFR as the recommended replacement for U.S. dollar LIBOR.
The CME Group begins publishing forward-looking Term SOFR rates (1-month, 3-month, 6-month, 12-month) based on SOFR futures market pricing. This was the key development that made SOFR practical for commercial lending — borrowers and lenders needed to know the rate at the start of each period, not the end.
Most new floating-rate commercial loans reference Term SOFR. The Federal Reserve begins aggressive rate hikes; SOFR rises sharply alongside the Fed Funds Rate, climbing from near zero to above 4% within 12 months. Rate cap premiums spike as implied volatility surges.
All remaining USD LIBOR settings cease publication. All legacy LIBOR-based contracts either converted to SOFR under the ARRC fallback provisions or were renegotiated. SOFR is now the sole benchmark for new and legacy U.S. dollar floating-rate instruments. Rate caps purchased on or after this date are entirely SOFR-based.
💡 If you have a legacy cap from before 2023: Confirm with your derivatives advisor that your cap confirmation document was updated under the ISDA LIBOR fallback protocol to reference SOFR with the appropriate credit spread adjustment. Most legacy caps were automatically converted, but documentation gaps exist in some older transactions.
The Three Main SOFR Variants — and Which One Matters for Your Cap
One source of genuine confusion for borrowers is that “SOFR” is not a single number — it comes in several forms, each calculated differently and used in different contexts. Understanding which variant your loan and cap reference is essential, because using the wrong variant in a calculation or discussion will produce the wrong numbers.
What it is: A forward-looking rate published daily by the CME Group, representing the market’s expectation of average SOFR over the next 30 days.
When it’s used: Most commercial real estate bridge loans with monthly interest resets reference 1-Month Term SOFR. It is set at the start of each interest period.
For your cap: If your loan resets monthly, your cap is almost certainly written against 1-Month Term SOFR. Each monthly caplet observes this rate at the start of its period.
What it is: Also published by CME Group, representing the expected average SOFR over the next 90 days. Slightly higher or lower than 1-Month Term SOFR depending on the shape of the forward curve.
When it’s used: Quarterly resetting loans, some permanent floating-rate structures, and certain syndicated credit facilities. Also the benchmark most commonly used for SOFR cap pricing models.
For your cap: Quarterly resetting caps use 3-Month Term SOFR. Each quarterly caplet covers one 3-month period.
What it is: The actual daily overnight SOFR rates compounded over an interest period. Only known at the end of the period — not the beginning.
When it’s used: Some syndicated loans and bond structures. Less common in commercial real estate because the rate is unknown until the period ends, making it difficult to plan cash flows.
For your cap: Less common for CRE caps. If your loan uses compounded SOFR in arrears, your cap must also reference this rate with appropriate observation shift or lookback provisions.
⚠️ Reference rate mismatch risk: Your cap’s reference rate must match your loan’s reference rate exactly — including the SOFR variant, the tenor, and any publication source specification. A mismatch between the loan’s rate and the cap’s reference rate means the cap settlements do not precisely offset the loan’s interest rate movements. Confirm both documents specify the same rate before closing.
Term SOFR in Practice: What Borrowers Actually Experience
Since Term SOFR is what the vast majority of commercial real estate borrowers encounter in their loan agreements and cap confirmations, it is worth spending time on what the practical experience of a Term SOFR-based loan actually looks like month to month — because this directly determines when and how your cap activates.
The monthly interest cycle on a Term SOFR loan
On a typical bridge loan with monthly interest resets using 1-Month Term SOFR, the cycle works as follows. A few business days before the start of each month — the “reset date” — the lender observes the current 1-Month Term SOFR rate. That rate, plus the credit spread, becomes the all-in rate for that entire month. The borrower knows their interest cost for the month before it begins. At the end of the month, the interest is due based on that fixed rate.
This predictability is the primary reason Term SOFR won out over compounded SOFR in arrears for commercial lending. A value-add multifamily operator managing a renovation project cannot effectively manage their cash flow if they do not know their interest expense until the final days of the month — they need to know at the start.
| Month | Reset Date | 1M Term SOFR Observed | Credit Spread | All-In Rate | Cap Strike | Cap Activates? |
|---|---|---|---|---|---|---|
| Month 1 | Nov 1 | 4.60% | 3.25% | 7.85% | 5.00% | No — below strike |
| Month 4 | Feb 1 | 4.90% | 3.25% | 8.15% | 5.00% | No — below strike |
| Month 7 | May 1 | 5.15% | 3.25% | 8.40% | 5.00% | Yes — 15bps above |
| Month 10 | Aug 1 | 5.60% | 3.25% | 8.85% | 5.00% | Yes — 60bps above |
| Month 14 | Dec 1 | 5.80% | 3.25% | 9.05% | 5.00% | Yes — 80bps above |
| Month 20 | Jun 1 | 4.75% | 3.25% | 8.00% | 5.00% | No — below strike |
Illustrative monthly rate path. The cap only activates in months where 1M Term SOFR exceeds the 5.00% strike. In months where it does not, the cap is dormant and the borrower pays the full floating rate.
The Waldev interest rate cap calculator prices your cap based on the current Term SOFR forward curve and implied volatility — showing you not just the total premium, but how each caplet is priced across your full cap term. Enter your loan details to see your estimated premium in seconds.
What Makes SOFR Move — and Why It Matters for Borrowers
SOFR does not move randomly. Its movements are closely tied to Federal Reserve monetary policy, broader economic conditions, and short-term liquidity dynamics in the U.S. financial system. Understanding the forces that drive SOFR helps borrowers anticipate when cap protection is most likely to be needed — and when the forward curve is likely to be pricing significant future rate risk.
The primary driver: Federal Reserve policy
The most important driver of SOFR is the Federal Reserve’s target range for the Federal Funds Rate — the rate the Fed sets for unsecured overnight interbank lending. Because SOFR reflects secured overnight repo transactions collateralized by Treasuries, it consistently trades very close to the lower bound of the Fed Funds Rate target range. When the Fed raises rates, SOFR rises within days. When the Fed cuts rates, SOFR falls within days.
This direct linkage means SOFR is fundamentally a monetary policy instrument from the borrower’s perspective. Rising inflation typically leads to Fed rate hikes, which drives SOFR higher, which increases floating-rate loan costs and activates rate cap settlements. The 2022–2023 cycle illustrates this dramatically:
Approximate illustrative values. Verify current SOFR at the NY Fed website or CME Group.
Secondary drivers
Treasury market supply and demand
Large-scale Treasury issuance can temporarily push repo rates higher as dealers need financing for newly acquired securities. Conversely, periods of low Treasury supply or high demand for repo borrowing can briefly drive SOFR below the Fed Funds floor. These fluctuations are typically small and short-lived, but they do appear in daily SOFR observations.
Quarter-end and year-end pressures
Financial institutions often reduce their balance sheet exposure at quarter and year end, reducing their participation in repo markets. This can cause SOFR to temporarily spike above the Fed Funds target range around these dates. Borrowers with interest resets on or near quarter-end dates may occasionally see this volatility in their reset rates.
How SOFR Directly Drives Your Rate Cap’s Performance
The relationship between SOFR and your interest rate cap is the central mechanism of the entire hedging structure. Here is how it works, step by step, in a way that makes the connection concrete.
The settlement calculation
Each month (or quarter, depending on your reset frequency), the cap settlement is calculated using a simple formula:
Monthly Cap Settlement = Notional Amount × Max(Term SOFR − Strike Rate, 0) × (Days in Period / 360)
Example A — SOFR below strike (cap dormant):
$12M × Max(4.85% − 5.25%, 0) × (30/360) = $12M × 0 × 0.0833 = $0
Example B — SOFR above strike (cap pays):
$12M × Max(5.80% − 5.25%, 0) × (30/360) = $12M × 0.55% × 0.0833 = $5,500
Example C — SOFR well above strike:
$12M × Max(6.40% − 5.25%, 0) × (30/360) = $12M × 1.15% × 0.0833 = $11,500
Those $5,500 and $11,500 payments are transferred directly to the borrower — or applied against the loan’s interest payment if the cap assignment agreement routes them to the lender. They represent a direct offset to the borrower’s increased interest expense caused by SOFR rising above the strike.
The cumulative effect over time
The real value of a cap is not in any individual monthly settlement — it is in the cumulative protection across all the months when SOFR is elevated above the strike. If SOFR averages 100 basis points above the strike for 18 months on a $15M notional, the cumulative settlements approach $225,000: $15M × 1.00% × (18/12) = $225,000. That is the cap returning its premium — or more — as protection in exactly the scenario it was designed for.
The SOFR Forward Curve: The Market’s Rate Forecast
When a cap dealer prices your cap premium, they are not guessing where SOFR will go. They are using the SOFR forward curve — a term structure of expected future SOFR rates derived from the SOFR futures market — as their base case for the expected settlements the cap will generate. Understanding the forward curve is therefore directly understanding the single most important input to your cap’s premium.
What the forward curve represents
The SOFR forward curve is a set of rates: one for each future period, representing what the futures market collectively expects SOFR to average during that period. The forward curve is derived from SOFR futures contracts traded on CME Group. Each futures contract settles at the average of daily SOFR over a specific month — and the price of that futures contract implies a market expectation for what that monthly average will be.
When you buy a 2-year cap today, the cap dealer looks at the forward curve for each of the 24 upcoming months and prices each caplet based on the probability that SOFR will exceed your strike during that month. Months where the forward curve already sits above your strike produce caplets with high intrinsic value. Months where the forward curve is well below your strike produce cheap caplets with only optionality value.
| Period | Forward Rate (Illustrative) | Strike | Caplet Status | Caplet Value Driver |
|---|---|---|---|---|
| Month 1–3 | 4.80% | 5.25% | OTM | Time value only — activation requires 45bps move |
| Month 4–8 | 5.10% | 5.25% | Near ATM | Time value + small intrinsic expectation |
| Month 9–14 | 5.35% | 5.25% | Slightly ITM | Intrinsic value + time value — market expects activation |
| Month 15–20 | 5.15% | 5.25% | Slightly OTM | Mostly time value — market uncertain about activation |
| Month 21–24 | 4.90% | 5.25% | OTM | Time value only — declining rate expectations |
The sum of all 24 caplet values — each priced based on the forward rate for its period, the strike, implied volatility, and the discount rate — is the total cap premium you pay at closing. You can see why the shape of the forward curve matters so much: if the curve sits above your strike for much of the cap term, the cumulative caplet values are higher and the total premium is larger.
Why the forward curve is not a guarantee
The forward curve represents the market’s best current estimate — but it has been wrong, sometimes substantially. During 2021, the forward curve consistently underestimated how high SOFR would rise during 2022–2023. Borrowers who priced caps in 2021 and held them through 2022 found their caps performing dramatically better than the forward curve had predicted, generating large settlement payments. Forward curves are informed estimates continuously updated by market participants, not contractual commitments about future rates.
Three SOFR Scenarios — What Each Means for Your Cap
Borrowers can get a very clear picture of how their cap performs by thinking through three distinct SOFR paths and tracing the outcome in each case. These are not predictions — they are analytical frameworks for understanding the cap’s asymmetric payoff profile.
| SOFR Scenario | Rate Path | Cap Settlement Payments | Borrower’s Net Rate | Cap Assessment |
|---|---|---|---|---|
| Bear scenario — rates spike | SOFR rises 150–200bps above strike within 12 months and stays elevated | Large — potentially exceeding total premium paid over cap term | Capped at strike + credit spread. Significant savings vs. uncapped rate | Cap performs excellently — more than justifies premium |
| Base scenario — rates hold flat | SOFR stays within 50bps of current level; occasionally crosses strike briefly | Small to moderate — some months generate small settlements, most generate none | Mostly floating; cap activates occasionally for modest offsets | Cap earns partial recovery of premium — some protection value |
| Bull scenario — rates fall | SOFR falls 100–150bps below current level; never approaches strike | Zero — cap never activates in any period | Fully floating — borrower benefits from lower rate than underwritten | Cap expires worthless but deal benefits from lower rate environment |
💡 The bull scenario demonstrates the cap’s core asymmetric value: in the scenario where protection is needed (rates rise), the cap pays out. In the scenario where it is not needed (rates fall), the borrower benefits from the lower floating rate instead. The premium is the bounded cost of having that asymmetry — a defined maximum expense with an unlimited potential return in adverse rate scenarios.
Practical Guidance for Borrowers: Tracking SOFR Before and During Your Loan
Understanding SOFR theoretically is useful. Having a practical routine for tracking it during your loan is more useful. Here are the habits and checkpoints that experienced borrowers and asset managers build into their processes.
Before closing: watch the forward curve, not just spot SOFR
Your cap premium is determined by the forward curve, not by today’s overnight SOFR print. In the weeks before closing, check the CME SOFR Term Rate page or a Bloomberg terminal to see the 1-Month Term SOFR for upcoming months. This is the input that most directly affects what you will pay — and understanding it helps you time execution and evaluate dealer quotes.
At each interest reset: verify your loan’s rate calculation
On each reset date, check the 1-Month Term SOFR published by CME Group and verify that your lender’s rate calculation matches. The rate should equal the CME-published 1-Month Term SOFR plus your contractual credit spread. Occasional errors in lender-calculated rates do occur — catching them requires knowing the published benchmark independently.
When SOFR exceeds your strike: confirm cap settlements are flowing
Once SOFR breaches your strike, verify that cap settlement payments are being received correctly. If your cap was assigned to the lender, confirm with your servicer that settlements are being credited against your interest due. If the cap pays directly to you, confirm that the settlement appears in your account within the required settlement period specified in your confirmation.
Quarterly: re-run your cap premium estimate
As SOFR and the forward curve evolve over your loan term, the residual value of your cap changes. Quarterly re-pricing — using the Waldev cap calculator with updated inputs — gives you a current market value estimate. This matters most when you approach a potential refinancing or sale, because it tells you whether a termination bid is worth pursuing.
Where to find current SOFR data
NY Fed SOFR page (newyorkfed.org/markets/reference-rates/sofr): Publishes the overnight SOFR rate each business morning. Also publishes SOFR averages and SOFR Index. Free and official.
CME Group Term SOFR (cmegroup.com/sofr): Publishes 1-month, 3-month, 6-month, and 12-month Term SOFR each business day. This is the rate referenced in most commercial loan agreements and cap confirmations. Free with registration.
SOFR futures quotes (CME Group): The futures market where the Term SOFR forward curve is derived. Visible through CME Group’s website or any futures data provider. Useful for understanding where the market expects SOFR to go.
Frequently Asked Questions
What is SOFR in simple terms?
SOFR (Secured Overnight Financing Rate) is a daily benchmark interest rate published each morning by the Federal Reserve Bank of New York. It measures the average cost of borrowing cash overnight using U.S. Treasury securities as collateral. It replaced LIBOR as the standard reference rate for U.S. dollar floating-rate loans and derivatives after June 2023. For commercial real estate borrowers, SOFR is the rate their floating-rate loan is indexed to — and the rate their interest rate cap monitors.
Why did SOFR replace LIBOR?
LIBOR was phased out primarily because it was based on bank estimates of their own borrowing costs rather than actual market transactions. This made it vulnerable to manipulation, which culminated in major rate-rigging scandals in 2012. SOFR is based on real, observable daily transactions in the U.S. Treasury repo market — typically over a trillion dollars per day — making it far more robust, transparent, and resistant to manipulation.
What is Term SOFR and why do most loans use it?
Term SOFR is a forward-looking benchmark rate published daily by CME Group for tenors of 1 month, 3 months, 6 months, and 12 months. It is calculated based on SOFR futures market pricing and represents the market’s expectation of average SOFR over the specified future period. Most commercial real estate loans reference 1-Month Term SOFR because it is known at the start of each interest period — unlike compounded SOFR in arrears, which is only known at period end. This advance knowledge is essential for cash flow planning.
How does SOFR affect my interest rate cap?
SOFR is the reference rate your cap monitors. Each period, the cap compares the current Term SOFR to your strike rate. If SOFR exceeds the strike, the cap seller pays you the difference multiplied by your notional amount and the period fraction. These payments directly offset your increased loan interest expense. The SOFR forward curve also determines your cap’s upfront premium — when the market expects SOFR to stay elevated above your strike, the expected settlements are higher and the premium is larger.
What is the difference between SOFR and the Fed Funds Rate?
The Fed Funds Rate is the target set by the Federal Reserve for unsecured overnight lending between banks. SOFR is the rate for secured overnight lending backed by Treasury collateral. SOFR typically trades very close to the lower end of the Fed Funds Rate target range. They are distinct rates — one is a policy target, the other is a market-observed transaction rate — but they move very closely together. A Fed rate hike almost immediately results in a corresponding SOFR increase.
Does SOFR go up when inflation rises?
Not directly — but yes, indirectly through Federal Reserve policy. When inflation rises persistently, the Fed typically raises the Fed Funds Rate to cool the economy and bring inflation down. Since SOFR trades closely with the Fed Funds Rate, SOFR rises in response. The 2022–2023 rate cycle is the most dramatic recent illustration: SOFR rose from near zero to above 5% as the Fed raised rates aggressively in response to multi-decade high inflation. That rate cycle drove enormous cap premium increases and large settlement payments for borrowers who already owned caps.
Is the SOFR forward curve a reliable prediction of future rates?
It is the market’s best current estimate, continuously updated, but not a guaranteed forecast. The forward curve reflects where professional market participants — including banks, hedge funds, and asset managers trading billions in SOFR futures — collectively expect rates to go. It is highly informed and generally better than any individual forecast. However, it can be wrong, sometimes substantially, when economic conditions change unexpectedly. The 2021 forward curve, for example, significantly underestimated the magnitude of rate increases that materialised in 2022.
Put SOFR Knowledge Into Practice
Understanding SOFR is the foundation for understanding everything about your rate cap — from the premium you pay at closing to the settlement payments you receive when rates move against you. The next step is putting actual numbers to your specific loan.
The Waldev interest rate cap calculator uses the current SOFR forward rate as a core input in its Black-76 caplet strip pricing model. Enter your loan’s notional, term, strike rate, and forward SOFR level to see a structured premium estimate with a full caplet breakdown — the same framework professionals use to price caps daily. For a quick estimate, use the calculator before any dealer conversation.
Estimate My Cap Premium →Related tools and guides in the Waldev finance tools category.
Disclaimer: This article is for educational and informational purposes only. All SOFR rate figures shown in charts and tables are illustrative approximations and should not be relied upon for any financial, legal, or transactional purpose. Current SOFR rates are published daily by the Federal Reserve Bank of New York (overnight SOFR) and CME Group (Term SOFR). Always verify current benchmark rates from official sources before any financial decision. This article does not constitute financial, legal, or derivatives advisory advice.
