SOFR vs Prime: how to compare business loans priced off different indices

What each index is

SOFR, the Secured Overnight Financing Rate, is published each business day by the Federal Reserve. It measures what large institutions pay to borrow cash overnight against Treasury securities, calculated from a very large volume of actual transactions. It replaced LIBOR as the benchmark for new floating-rate business loans. Because an overnight rate is awkward for a monthly loan payment, most business loans use Term SOFR, a forward-looking rate for one, three or six months derived from futures markets and fixed at the start of each interest period. Some use daily SOFR averaged over the period instead. The glossary entry on SOFR plus a spread covers how the loan rate is built.

Prime is not a market rate. It is a rate banks set and publish, and the widely quoted version is a survey of what the largest banks charge. By a convention that has held for decades, banks set it three percentage points above the upper end of the Federal Reserve's target range for the federal funds rate, and they change it as soon as the Fed moves, usually effective the next business day. A bank can also define its own prime rate in its loan documents, which usually follows the published one.

So both indices follow the Fed. The difference is that Prime moves only when the Fed does, in steps, while SOFR moves every day with conditions in the funding market, usually within the Fed's range but with occasional spikes around quarter-ends and tax dates. Term SOFR smooths most of that out.

Why they sit about three points apart

SOFR trades inside the Fed's target range. Prime sits three points above the top of it. The distance between them is therefore a little more than three percentage points on most days, because SOFR is usually below the top of the range, not at it. That gap is structural. It does not mean Prime lenders are more expensive, only that the number they start from is higher, so the spread they add is smaller.

The consequence for anyone comparing term sheets: a spread over Prime and a spread over SOFR are not the same unit. A spread over SOFR for a given borrower will be roughly three points wider than a spread over Prime for the same risk. A strong borrower at a bank may be quoted Prime flat, or even Prime minus a fraction, which is roughly the same as SOFR plus something under three.

Never compare a spread over SOFR to a spread over Prime. Put both on the same index first.

Converting one quote into the other

The table uses a round gap of three points for illustration. On any given day the real gap is usually slightly larger, which makes a SOFR quote slightly cheaper than the table shows. To be exact, look up both indices on the day you compare and use the actual difference.

A worked example in plain numbers. On a loan of 4,000,000, the difference between Prime plus 1 and SOFR plus 3.5 is about half a point, or about 20,000 a year of interest, in favor of the SOFR quote. An owner comparing the two by their spreads alone would have picked the more expensive loan and believed it was cheaper by two and a half points.

Spreads, floors and the fine print

Converting the index is the first step, not the last. Three other terms change what a floating-rate loan really costs, and they tend to differ between Prime-based and SOFR-based lenders.

• Floors. Many loans set a minimum on the index, or on the all-in rate, so the rate cannot fall below it however low the market goes. A SOFR floor sets a minimum on SOFR; a rate floor on a Prime loan often sets a minimum on the total rate. A floor costs nothing while rates are above it and starts to matter when they fall. Compare floors on the same basis too: a SOFR floor and a Prime-loan rate floor are not the same kind of number. See interest rate floor.
• Day count. Most business loans charge interest on an actual/360 basis: each day's interest is the annual rate divided by 360, so a full 365-day year costs slightly more than the quoted rate. Some Prime-based loans at smaller banks use actual/365. The difference is small but real, and it applies to the whole rate, not just the spread.
• Fees. Origination fees, unused line fees on a revolver, and prepayment terms often differ more between lenders than the rate does. The interest rate vs all-in cost comparison shows how to fold them into one number.
• The fallback rate. Many SOFR-based credit agreements also define a base rate, the highest of Prime and two other benchmarks, and charge it when a SOFR rate cannot be set or for short-notice borrowings on a revolver. The spread on base-rate borrowings is set lower than the spread on SOFR borrowings, which is the agreement's own admission that the two indices sit apart.

Which lenders use which

SBA loans deserve a word. SBA caps the rate on a variable 7(a) loan as a spread over the base rate: plus 6.5% for loans of $50,000 or less, plus 6% from $50,001 to $250,000, plus 4.5% from $250,001 to $350,000, and plus 3% above $350,000. Most SBA lenders use Prime as that base, so an SBA quote is usually read as Prime plus a spread under the cap. Current quotes across SBA lenders are on SBA loan rates, and the maximum rate entry explains the cap.

Does the index itself make a difference?

Once two quotes are on the same basis, the index matters in a few narrower ways.

• How rates reach your payment. Prime changes as soon as the Fed moves, and a Prime loan usually reprices from the date Prime changes. A Term SOFR loan reprices at the start of each interest period, so the market's expectations of the Fed show up earlier and the Fed's actual move shows up a little later.
• Hedging. Swap and cap markets are built on SOFR. A SOFR loan can be hedged cleanly; a Prime loan is harder to hedge with a standard instrument, which is one reason banks offering Prime-based loans often offer a fixed rate as the alternative. The swap vs cap comparison explains the choice where hedging applies.
• Predictability. Prime moves in visible steps; SOFR can move a little between Fed meetings. For most borrowers the difference is minor next to the choice between floating and fixed, covered in fixed vs variable rate.
• Coverage. Whichever index a loan floats on, the lender tests debt service coverage on the payment. A floating loan sized at today's rate has less headroom if rates rise, whatever the index is called.

Transparent lays out competing offers from its lender book on one basis, index converted, floors and fees included, so an owner compares the cost of the money and not the way it was quoted. The same financing model runs coverage at higher base rates, which is the test a lender will run on a floating loan. See how we underwrite and the lender book.