How do interest rate swaps work? How do you make it benefit you?
If you have a commercial loan with fluctuating rate, then you are in a favorable position to monitor your interest rates.
Any adjustments in interest rate will affect your borrowing costs, thereby making your monthly payments uncertain. Adjustments made to interest rates will make it difficult to forecast the value of loan repayment.
Interest rate swaps provide a good option if you would like to maintain a fixed rate of debt service without moving to the normal fix-rate loan.
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What Are Interest Rate Swaps?
An interest rate swap is an agreement in which two parties decide to exchange one flow of interest payments for another.
This rightly depends on a particular rate index and capital.
Interest rate swaps normally involve the exchange of a fixed interest rate for a floating rate.
Or the other way round, just to minimize or increase the chances of fluctuations in interest rates, or to earn a marginally lower interest rate than would have been possible without the swap.
Furthermore, an interest rate swap can be a useful idea for guarding against any possible risk arising from a fluctuating interest rate. It also has several benefits for both new and existing loans.
This post highlights how interest rate swaps work and how they can benefit you.
Let’s dig in…
How Does An Interest Rate Swaps Work?
An interest rate swap essentially converts the interest rate on a fluctuating rate loan into a fixed cost.
This works through an exchange of interest payments between you the borrower and your lender, bank, or any other financial institution.
In this case, you are mandated to pay the fluctuating rate interest payment on the loan every month.
You will also make another payment to the lender, depending on what the swap rate is. The lender then reduces the fluctuating rate amount so that you ultimately pay a fixed rate.
In lay terms, here’s an interest rate swaps example:
Let’s say you have a variable rate home equity line of credit, which you used part of it to do a home improvement project.
You may ask your lender if they will be willing to fix the rate on your outstanding balance, effectively creating a fixed rate home equity loan.
So if you have a $50,000 line of credit but have only used $20,000 for renovation, you could ask for a fixed rate to be applied to the $20,000.
However, as said earlier, interest rate swaps aren’t for personal affairs.
It is mostly used by businesses like yours, particularly, to hedge against or speculate on changes in interest rates. Hence, interest rate swaps are also popular for the arbitrage opportunities they offer.
Read: Here’s how to shop around for the best personal loan rates
Benefits of Interest Rate Swaps
1). Flexible for Borrowers
Interest rate swaps give you, the borrower, the flexibility of separating your source of funding from the interest rate risk.
This ultimately allows you to access more funding to meet your needs, and also helps you to create a swap structure to achieve some important goals.
2). Risk Management
A lender may find interest rate swaps as a useful tool in minimizing the risk. This means that the bank can manage its interest risks not only at the loan by loan level, but also at the macro or balance sheet level.
Normally, you are more focused on increasing the chance of making more profit and are willing to take more risks by swapping a fixed rate interest flow for one that is fluctuating. Both parties benefit by better combining financial positions with company needs.
3). Gives the borrower access to financing
Sometimes, your company may have access to financing with unsteady interest rates, and without any fixed-rate borrowing.
At this point, interest rate swaps can be beneficial in allowing you to tap into the credit worthiness of another firm to receive the type of financing that you truly require.
4). Prepayment benefits
The lender or bank will be able to create prepayment discipline which is better for acquiring the economic value of equity than fixed-rate loan prepayments where penalties are often waived.
On the other hand, you have bilateral make whole with the swap, which means the swap might be an asset, and you would receive the value of that asset on the way out.
Types of Interest Rate Swaps
There are three basic different types of interest rate swaps; Fixed-to-floating, floating-to-fixed, and float-to-float.
Here are detailed explanation of each type:
a). Fixed -to -floating
For instance, your company may have the capacity to issue a bond at a very reasonable fixed interest rate to its investors. The management of your organization feels that it can earn more cash streams from a floating rate. At this juncture, you can agree to a swap with a different bank where you receive a fixed rate and pay a floating rate.
The swap is designed to pair with the income flow and the maturity of the fixed-rate bond, and the two fixed-rate payment streams are received as profit.
Now, your company and the bank choose the preferred floating-rate index, which usually goes between one and three months of maturity.
Your company then receives a benchmark interest rate addition or a minus spread that reflects both interest rate conditions in the market and its credit rating.
b). Floating-to-Fixed
When your company cannot access a fixed-rate loan, you may decide to borrow at a floating rate and make a swap to achieve a fixed rate.
The implication of this is that the duration of the floating rate as well as reset and payment dates are reflected on the swap and profits made. The fixed rate of the swap now becomes your borrowing rate.
c). Float-to-Float
Sometimes, you may go into a swap to adjust the type or duration of the floating rate index that they pay; this is generally referred to as a basis swap.
You can swap from the three-month benchmark interest rate to about six months, for instance, maybe because the rate is irresistible or it pairs with other payment streams. You can also change to a different index, just like the federal funds rate, or the Treasury bill rate.
Appropriate Time to Use An Interest Rate Swap
Your company may use an interest rate swap when:
1). You seek protection against any possible future interest rate. Given this situation, your company would exchange its fluctuating rate payment for a fixed-rate payment.
2). The second option is that you may be aiming to capitalize on any information that interest rates might fall in the nearest future.
With this belief, you would exchange your fixed-rate payment for a floating rate payment.
Normally, the transaction can only take place when one party has the feeling that the interest rate might either ride or fall in their favor.
The implication is that one of the parties will be right while the other will be wrong, but they may not know at the initial time. This is the reason interest rate swap has a risky tendency.
Depending on the estimated amount involved, being in the wrong position of the swap can be costly.
An interest rate swap may look challenging at the onset, but immediately after the calculations are spelled out, it will be as very easy as paying a fixed amount every month.
Conclusion
An interest rate swap is a commercial product that offers real benefits to the borrower and the lender. It is the most outstanding solution to meet the needs of the bank and the borrower.
Do you have a commercial loan outstanding? Then consider speaking to your lender or financial institution to discover if interest rate swaps are advantageous for you.
