If you like the idea of taking advantage of today’s low variable interest rates, but like the security of a fixed rate, an interest rate swap may suit your needs.

Technically, an interest rate swap is an agreement between your company and its bank to exchange payments based on specific interest rates and specific levels of debt. Although the transaction is entirely separate from your loan, the swap interest payments are usually tailored to precisely match the timing of your loan payments.

Here’s how a swap would work. Let’s assume that you obtain a variable rate loan from your bank priced at Prime plus 1.5%. You will always make these loan payments, but in addition to the regular variable payments, you enter into a swap agreement with your bank.

In a swap, you agree to pay the bank a fixed interest payment based on your loan amount while they simultaneously pay you a variable interest payment in return. This sounds a bit confusing at first, but is illustrated in the table at right.

In the example shown here, we’ve made the following assumptions:

1)      You are borrowing over five years.

2)      You have agreed to pay the bank a fixed rate of 8.95%.

3)      The bank has agreed to pay you at Prime.

4)      Prime is 8% the first year, then increases by 0.5% each year.

As can be seen in this example, any upward increase in the prime rate is offset by the variable payment from the bank.

At this point you may be thinking, well why not just take a fixed rate? The answer lies in the commencement date of the interest rate swap.   As long as your variable payment is less than the net effective loan rate, you don’t need the swap. In year three, however, the swap becomes cost-effective.

Ideally, therefore, you want a swap agreement to kick-in only at the point where it saves you money. In essence, this concept is called a swap option agreement. What that means is that at your option, your swap agreement becomes effective. In our example, that would be year three.

To enter into a swap option agreement, expect to pay a fee to the bank to keep your option open. While Prime is low, you will compensate the bank for having the option. If Prime shoots up, and you exercise the option, you’ll have capped your interest at the net effective rate no matter how high Prime goes!

This concept is not unlike fuel price hedging where you are paying a small premium to protect yourself against price increases.

Since interest rate swaps are a fairly complex transaction to track, very few small community banks will have the ability to offer you the service. Almost all regional and national banks offer interest rate swaps, but you may have to ask for them and they may not be handled through the commercial loan department. Instead, you will find the swap agreements in capital markets or risk management departments.

Why would a bank offer swap agreements? Two answers — income and portfolio management. Banks are constantly struggling with asset and liability management in the forms of deposits and loans. Swap agreements can be just as advantageous to your bank as they are to you.

So, if you have concern over any current or future variable rate loans, ask your banker about interest rate swaps. They may be just the piece of mind you need at a very small cost.

Interest Rate Swap Example

Year 1

Year 2

Year 3

Year 4

Year 5

Regular variable rate on loan

9.5%

10.0%

10.5%

11.0%

11.5%

Pay negotiated fixed rate to bank

8.95%

8.95%

8.95%

8.95%

8.95%

Receive variable rate from bank

<8.0%>

<8.5%>

<9.0%>

<9.5%>

<10.0%>

Net Effective Loan Rate

10.45%

10.45%

10.45%

10.45%

10.45%

 

PetroAnswers Interest Rate Swaps