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What to know about interest rate swaps

What to know about interest rate swaps

For managing today’s costs and planning ahead for the future, an interest rate swap could be advantageous for your organization. While an interest rate swap may seem complex at first, it is a strategy for corporations and lenders alike to manage debt and manage risk more effectively.

An interest rate swap allows you to secure a fixed rate, without some of the drawbacks from a traditional fixed rate loan. Plus, an interest rate swap can be a smart move to protect against the future rise of interest rates. Explore how swaps work, and why a swap could be the right move for your company.

Interest rate swaps, defined
Essentially, an interest rate swap is an exchange of future interest receipts. One stream of future interest rates is exchanged for another, based on a determined principal amount. An interest rate swap transforms the interest on a variable rate loan into a fixed cost. Also called an interest rate hedge or interest rate derivative, an interest rate swap can be a smart alternative to fixed rate funding.

How interest rate swaps work
A swap functions the same way as a traditional fixed rate loan in that a company has certainty on how much interest they will pay. The borrower still pays the variable rate interest payment on the loan each month, typically determined according to LIBOR (The London Inter-bank Offered Rate) plus a credit spread.

Then, the borrower makes an additional payment to the lender based on the swap rate, which doesn’t change from month to month. The lender rebates the variable rate amount, so ultimately the borrower pays a fixed rate.

Who might benefit from an interest rate swap
If your organization has a loan with a variable rate, you likely keep close tabs on interest rates. Because a shift up or down in interest rates impacts borrowing costs, it can be more challenging to forecast what you will pay each month. And if interest rates do tick up, your organization may owe larger interest payments. So an interest rate swap could be helpful for your company.

Interest rate swaps can be beneficial for borrowers who anticipate excess cash flow. If rates spike on the floating side, you can pay that portion of the loan off more quickly. You can leverage an interest swap to take control of debt management.

An interest rate swap may also be worth considering if you expect floating rates to remain low. For example, if your company has a seven-year loan in place, it’s possible to keep a floating rate for the first two years and shift to fixed for the next five. Unique design becomes a realistic scenario with interest rate swaps.

Why an interest rate swap could be right for you
Interest rate swaps offer a pathway towards more strategic cash flow management. With the swap rate secured, your company will know exactly how much interest is owed each month. Swaps also give you access to flexible prepayment penalties, potentially minimizing what you owe. And, many companies enjoy a locked in fixed rate that will start on a date in the future. With a swap, you may be able to secure a rate that would begin months (or years) later.

Another advantage is the flexibility and creativity of an interest rate swap. A swap can be completed on either your whole loan or a portion of your loan. You can obtain an interest rate swap on just some of your loan, maintaining a floating rate for the rest. There are many sophisticated features of a swap that borrowers find attractive.

Due to the market value of the swap, borrowers should be aware of accounting implications and the impact that may have on the balance sheet. It’s something to consider if you’re planning an interest rate swap.

Interest rate swaps can be completed in a number of ways, with multiple sophisticated features, to achieve your goals. Ultimately, your Commerce team is on your side, helping you make smart, strategic moves for your company. Get in touch with us to see how an interest rate swap can be advantageous for you.

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