How interest rate swaps work and why they're useful.

If you have a loan with a variable rate, you keep a close eye on interest rates. A change in interest rates affects your borrowing costs and can make it difficult to anticipate what you'll pay month-to-month. Changes in variable rate indexes can make it difficult to forecast debt service levels. If you would like to secure a fixed cost of debt service but not move to a traditional fixed rate loan, an interest rate swap could be a good fit.

Interest rate swaps are a useful tool for hedging against variable interest rate risk. For both existing and anticipated loans, an interest rate swap has several strategic benefits. To make smart use of an interest rate swap, it helps to understand how a swap works. Here's what you need to know:

How an interest rate swap works.

Ultimately, an interest rate swap turns the interest on a variable rate loan into a fixed cost based upon an interest rate benchmark such as the Secured Overnight Financing Rate (SOFR). It does so through an exchange of interest payments between the borrower and the lender. (The parties do not exchange a principal amount.)

With an interest rate swap, the borrower still pays the variable rate interest payment on the loan each month. For many loans, this is determined according to the applicable benchmark, (generally SOFR, plus a spread adjustment) plus a credit spread. The credit spread isn't part of the swap and is always paid on top of the swap rate. Then, the borrower makes an additional payment to the swap counterparty based on the swap rate.

The swap rate is determined when the swap is set up with the lender and is unchanging from month to month. Finally, rather than issuing a literal rebate, the two payment streams are netted, meaning the only difference between the fixed swap rate and the benchmark-based variable rate changes hands. This netting is usually calculated and settled periodically (often quarterly) even if loan payments are monthly.

Ways to leverage a swap.

An interest rate swap is excellent for protecting against an expectation of higher interest rates. And, due to the nature of interest rate swaps, there are many additional advantages to be aware of and leverage. Here are a few:

• Cash flow management. Once you secure the swap rate, you'll know exactly how much you'll be paying each month. Your "all-in" fixed cost will be the swap rate plus your loan's credit spread. Let that certainty be the foundation for smart, strategic plans.
• Access flexible prepayment penalties. In a fixed rate loan, you may pay a prepayment penalty if at some point you sell the financed property or your business and pay off your remaining outstanding loan balance. A variable rate loan does not have a prepayment penalty, but if you enter an interest rate swap and pay off your loan early, you would need to settle the swap contract at market value at that time. Because the contract is canceled at market value, you could either be in a liability position and owe something to swap counterparty, or you could be in an asset position and receive a payment from them upon termination.
• Secure a future rate. A traditional fixed rate loan can guarantee a rate in the short-term. When you complete a swap on a floating rate loan, it's possible to lock in a fixed rate that will start on a date in the future. You may be able to secure a rate that would start months, or even years, later.
• Complete a swap on a portion of the loan. A swap doesn't have to be completed on the entirety of your loan. You can obtain an interest rate swap to secure a set rate on a portion of the loan, so that you still have a floating rate for the rest. This affords more flexible and creative options for your portfolio.

Things to consider.

While providing great solutions for managing borrowing costs, swaps have a few more moving parts than your traditional fixed rate loan structures. Here are a few considerations to discuss with your lender:

• Documentation. With your swap contact and the help of your lender, you must complete standard swap documentation before starting. The agreement doesn't commit you to completing the swap.
• Accounting. Interest rate swaps with structures to match the terms of the initial loan may qualify for hedge accounting. Consult with your accountants and/or auditors to determine if hedge accounting is appropriate for your situation.
• Regulatory. The Wall Street Reform and Consumer Protection Act (the Dodd Frank Act) outlines eligibility and suitability requirements for any parties entering an interest rate swap agreement. These include documentation and reporting requirements that the bank or swap counterparty will help you navigate.

An interest rate swap may seem intimidating at first, but once the mechanics are worked out it's as simple as paying a fixed amount each month when viewed in terms of total interest cost predictability.

Also See:

• LIBOR Q&A
• 5 Ways Tech Tools Can Save Time for Your Business