Variable Rates: What to Consider for Student Loan Refinancing

If you have any variable interest debt or are thinking of taking on any variable interest debt, you should be familiar with SOFR, an interest rate benchmark that’s used as a reference rate for a wide range of financial transactions.

What is SOFR?

SOFR is the “Secured Overnight Financing Rate” and it’s used to calculate interest rates on debt such as consumer loans, mortgages, credit cards, derivatives and corporate bonds. SOFR is calculated using the volume-weighted average of over 1 trillion dollars in transactions on a daily basis in the US Treasury repo market.

The US Treasury repo market is where the US Federal Reserve conducts monetary policy by both buying and selling short-term debt to major banks and broker-dealers, known as primary dealers. The debt is typically sold and repurchased (or repo’d) overnight. Thus, the repo market is a good proxy for short-term interest rate levels.

When banks, credit card companies and financial service companies (such as student loan lenders) determine what interest rate they’ll offer you on a loan, they typically base their rate off a benchmark. They’ll add a premium to the benchmark rate that builds in a profit margin for themselves and reflects your credit score and perceived risk as a borrower.

Prior to the adoption of SOFR in 2023, the benchmark that had been used for nearly 40 years was LIBOR, “the London Interbank Offering Rate.”

What is LIBOR?

The London Interbank Offer Rate (LIBOR), was the interest rate global banks used to charge each other for short-term loans on the London interbank market. It was determined by a daily survey of up to 18 global banks, called “panel banks.” The highest and lowest numbers from the survey were removed and the rest of the numbers were averaged. It was based on five different currencies (US dollar, the euro, British pound, Swiss franc, and Japanese yen) and is used for seven different debt maturities:

• overnight/spot
• 1-week
• 1-month
• 2-month
• 3-month
• 6-month
• 12-month

The maturity that is quoted most often is the 3-month US dollar rate, often called the “current rate.“

Why the switch from LIBOR to SOFR?

You might be wondering why the switch from LIBOR to SOFR. The reasons were simple: the industry was moving away from using it as a benchmark in the aftermath of the 2008 financial crisis and LIBOR was no longer trustworthy.

One of the fallouts of the 2008 crisis was that fewer banks were participating in the interbank market and the banks that continued to participate were making fewer transactions, hence the numbers on which LIBOR was based were becoming less representative of market interest rates and began to incorporate more estimates, instead of actual transaction data.

The method with which LIBOR was calculated also became mired in scandal. To come up with the LIBOR numbers, a group of panel banks were surveyed, and they reported the prices at which they traded the various debt instruments outlined above on a daily basis. But because it was a survey, the panel banks could manipulate the numbers they reported. And in 2012, it was discovered that multiple traders at panel banks did just that. Once the manipulation was discovered, the trust that underpinned LIBOR was severely undermined and the search for a new benchmark began in earnest. But building a new benchmark for billions of dollars of credit took time.

Here are some key dates in the search for a new benchmark:

• November 17, 2014: the US Federal Reserve convened the Alternative Reference Rates Committee (ARRC) to help find a new benchmark for financial market participants to use instead of LIBOR.
• July 27, 2017: the FCA, the UK regulatory body that oversees LIBOR, announced that panel banks would no longer be required to submit LIBOR rates as of the end of 2021.
• March 5, 2021: the FCA announced that submissions for all UK pounds, Euro, Swiss francs, and Japanese yen would end on December 31, 2021, and for US dollars on June 30, 2023.
• July 29, 2021: the ARRC completed their search for a new benchmark and formally recommended switching to SOFR.

With the pending demise of LIBOR and an official recommendation for the new SOFR benchmark, the next step was for all market participants to prepare for the switch. The ARRC developed the Paced Transition Plan, which had specific steps and timelines for market participants to follow to help encourage a smooth transition to SOFR.

Making the switch to SOFR

As of October 29, 2021, variable rates offered to new Laurel Road student loan applicants are based on SOFR. If you already had variable interest rate debt (scheduled to come due after 2021), your loan terms may contain a clause that explains what will happen if your loan’s benchmark changes. If so, your lender has likely switched from using LIBOR as the benchmark to using SOFR. But to be sure, consult your lender to see how your loan has been impacted by the switch. If you currently have a variable rate student loan with Laurel Road, read more here.

If you’re looking for a new loan and choose to go with a variable rate, your interest rate will be subject to change based on changes to the 30-day average SOFR. This means that your starting rate will be determined when you close your loan.

Fortunately, because the SOFR is based on actual daily transactions in the US Treasuries marketplace, it’s a more reliable and lower risk benchmark than LIBOR. This means the interest rates that’ll be assigned to your existing variable rate debt as well as the rates you’re quoted in any applications you make for credit should be a closer representation of market interest rates.