If you have a loan with a variable rate, there’s a good chance that you keep a close eye on interest rates. A change in interest rates will impact your borrowing costs and make your monthly payments uncertain. Changes in variable rate indexes can make it difficult to forecast debt service levels. An interest rate swap could be a good fit if you would like to secure a fixed cost of a debt service without moving to a traditional fixed rate loan.
An interest rate swap is a useful tool for hedging against variable interest rate risk. For both existing and upcoming loans, an interest rate swap has several benefits. To make the most of interest rate swaps, here is what you should know about them and how they work.
What is an interest rate swap?
An interest rate swap is a derivative contract where two parties agree to exchange one stream of interest payments for another. This will be based on a specified rate index and principle amount. In the world of commercial real estate lending, the most common type of interest rate swap is a fixed for floating exchange. In this case, one party exchanges a fixed stream of interest rate payments for a floating rate stream of payments.
How does an interest rate swap work?
Essentially, an interest rate swap turns the interest on a variable rate loan into a fixed cost. It does so through an exchange of interest payments between the borrower and the lender. The borrower will still pay the variable rate interest payment on the loan each month. They then make an additional payment to the lender based on the swap rate, which is determined upon set up. The lender then rebates the variable-rate amount, so that ultimately the borrower pays a fixed rate.
What is it appropriate to use an interest rate swap?
In commercial real estate, an interest rate swap typically becomes an option when:
- A borrower is looking for protection against rising interest rates in the future. In this situation, they would exchange their variable rate payment for a fixed rate payment, or
- A borrower is looking to capitalize on their belief that interest rates are going to fall in the future. They would exchange their fixed rate payment for a floating rate payment.
Typically, the transaction can only occur when one party believes that interest rates will rise or fall in their favor. One of the parties will be right and the other will be wrong, but it may not be clear at the time, which is why interest rate swaps tend to be inherently risky. Depending on the notional amount involved, being on the wrong side of the swap can be an incredibly costly proposition.
An interest rate swap may seem daunting at first, but once the mechanics are worked out, it is as simple as paying a fixed amount each month.
Do you have questions about interest rate swaps? At Fidelity, we are committed to providing loans to borrowers that larger lending institutions are unable or unwilling to fund. Our constant growth is a direct relation to our response to the changing real estate marketplace while serving a growing community of property owners and investors. We look forward to working with you.