Interest Rate Swap Basics for Large Commercial Mortgages

How do interest rate swaps work for large commercial mortgages?

Interest rate swaps are customized derivative contracts banks and corporate borrowers use to reshape interest-rate risk on large commercial mortgages. Rather than changing the loan itself, a swap lets a borrower keep their underlying mortgage while exchanging the variability of future interest payments for a different cash‑flow profile (for example, fixed instead of floating). Swaps are now primarily referenced to SOFR (Secured Overnight Financing Rate) in U.S. markets after the phaseout of LIBOR; that change affects pricing, compounding conventions, and documentation (see the ARRC and Federal Reserve guidance).

This article explains practical mechanics, documentation, risks, and strategic considerations for commercial mortgage borrowers, with links to related FinHelp resources to help assess whether a swap fits your financing plan.

Key components of an interest rate swap

• Notional principal: A reference amount used only to calculate payments. The notional is not exchanged.
• Fixed leg: One party agrees to pay a pre‑agreed fixed interest rate on the notional.
• Floating leg: The counterparty pays a variable rate tied to a benchmark (today, typically SOFR + a spread).
• Net settlement: Only the net difference is paid on each payment date; the larger payment offsets the smaller.
• Term and schedule: Payment frequency, reset dates, and maturity that should align with the mortgage’s cash‑flow profile.

Example (illustrative): A borrower has a $20 million floating‑rate mortgage priced at SOFR + 2.0%. To remove rate volatility, the borrower enters a pay‑fixed / receive‑floating swap on the $20 million notional. If the swap fixed rate is 4.0% and the floating leg is SOFR each quarter, on each settlement date the borrower pays the swap fixed rate and receives SOFR, then nets the difference. Economically, the borrower transforms their loan exposure from SOFR + 2.0% into effectively a fixed rate of roughly 4.0% + any spread/fees—depending on how the swap and loan cash flows are structured.

Note: After the cessation of LIBOR benchmarks, most new USD swaps reference term or compounded SOFR. See the Alternative Reference Rates Committee (ARRC) and ISDA guidance for protocol details (New York Fed/ARRC; ISDA).

How swaps are used with large commercial mortgages

• Convert floating-rate loans to fixed payments (pay fixed/receive floating).
• Convert fixed-rate obligations to floating if a borrower expects rates to fall (receive fixed/pay floating).
• Match an amortizing mortgage by using an amortizing swap or a series of swaps whose notional declines with the loan balance.
• Buy optionality with swaptions (the right, not obligation, to enter a swap) when the borrower seeks protection but wants flexibility.

Common structures for commercial mortgages:

• Amortizing swaps: Notional reduces with the loan, avoiding basis mismatches over time.
• Forward-starting swaps: Agreed today but begin at a future date, useful when a loan will reprice or a refinance is planned.
• Swaptions: Useful when borrowers want upside if rates fall but protection if rates rise.

Documentation and legal framework

Most institutional swaps are governed by an ISDA Master Agreement with a trade confirmation and often a Credit Support Annex (CSA) that defines collateral and margining rules. Key documents specify termination events, netting, and default remedies. Lenders may require a borrower to disclose hedging and to coordinate swap terms with loan covenants. Work with counsel experienced in ISDA and commercial mortgage documents.

Accounting and regulatory considerations

Swaps interact with accounting standards (U.S. GAAP ASC 815 / hedge accounting) and can affect reported earnings and balance‑sheet presentation. Borrowers seeking hedge accounting must document the hedge relationship, measure effectiveness, and follow disclosure rules. Tax impacts vary with structure and jurisdiction—ask a CPA or tax counsel for a loan‑level analysis.

Regulators and market groups have updated guidance since the LIBOR transition; confirm benchmark conventions and fallback language in new contracts (see Federal Reserve and ARRC publications).

Risks to understand

• Market (interest rate) risk: Swaps change but do not eliminate exposure; residual basis risk may remain if the loan and swap reference different benchmarks or compounding methods.
• Counterparty/credit risk: The other party may default. Larger borrowers often transact with dealers that post collateral under a CSA to reduce credit exposure.
• Liquidity and unwind risk: Early termination or replacement can require a significant cash payment if the swap has moved against you.
• Operational risk: Mismatched payment dates, day count conventions (e.g., ACT/360 vs ACT/365), or notional amortization schedules can create unexpected cash flows.
• Legal and covenant risk: Some loan agreements limit swap counterparties or require lender consent.

Practical steps and professional tips

1. Align terms: Match the swap’s notional profile, payment frequency, and maturity to the mortgage schedule to limit basis risk.
2. Check benchmark and compounding: Ensure both loan and swap use compatible rate conventions (e.g., compounded SOFR vs simple overnight SOFR) to avoid small but recurring mismatches.
3. Evaluate counterparties: Ask about dealer creditworthiness, CSA terms, and the likelihood of margin calls in stressed markets.
4. Stress-test scenarios: Model rising, falling, and volatile rate paths and their effect on net cash flows and covenant compliance.
5. Consider alternatives: Interest rate caps, floors, or collar strategies can limit upside cost while providing protection.
6. Read the fine print: Understand early termination valuation, breakage fees, and any embedded options the lender has.
7. Use professional advisors: Work with treasury advisors, legal counsel, and accountants who routinely handle ISDA documentation and hedge accounting.

In my practice I’ve seen well‑matched amortizing swaps materially reduce cash‑flow volatility for large borrowers while poorly structured trades created unexpected margin requirements and termination losses. That experience underscores the value of careful documentation and scenario analysis.

Common mistakes and misconceptions

• “Swaps eliminate all interest risk.” They reduce or change it; basis and credit risk remain.
• “LIBOR still applies.” LIBOR has been phased out for most USD derivatives; use SOFR‑based conventions for new trades (ARRC guidance).
• “All swaps are identical.” Swaps differ by benchmark, day count, payment frequency, amortization, collateral terms, and termination mechanics—these differences matter.
• Ignoring accounting: Failure to plan for hedge accounting can produce earnings volatility.

Illustrative numeric example (simple)

Borrower A: $10,000,000 mortgage at SOFR + 2.00%, pays quarterly. Borrower wants fixed cash flows.
Swap: Pay fixed at 4.00% on $10,000,000, receive floating (compounded SOFR) quarterly.

On a given quarter, if compounded SOFR is 1.0% (annualized), floating leg ~1.0% and borrower nets pay fixed 4.00% minus receive 1.00% = net 3.00% on the notional. Combined with the loan spread (+2.00%), the borrower’s all‑in rate is roughly 5.00% for that quarter. If SOFR rises to 3.0%, the swap receive leg increases and the borrower’s net fixed economics adjust accordingly. This example is illustrative; actual cash flow depends on compounding, payment calendar, and the loan’s spread mechanics.

When to consider a swap vs other hedges

• Consider a swap when you need long‑term, stable budgeting for debt service and want to lock a rate with predictable cash flow.
• Consider a cap or collar when you want upside participation if rates decline but protection against large increases.
• Review our guide on When to Consider Interest Rate Hedging for Your Mortgage for a deeper decision framework.

Also see related discussions of market drivers and structure in Evaluating Yield Curve Risk in Mortgage Financing and how hybrid products compare at Hybrid ARM Mortgages: Understanding Initial Periods and Recasts.

Quick checklist before you trade

• Confirm loan covenants allow the hedge and whether lender consent is needed.
• Match or explicitly model benchmark and compounding conventions.
• Get multiple quotes and review dealer CSA terms and collateral thresholds.
• Model worst‑case margin calls and termination amounts under stressed rates.
• Coordinate accounting and tax advisors to document hedge intent if seeking hedge accounting.

Professional disclaimer

This content is educational only and does not constitute financial, tax, or legal advice. Swap transactions are complex and carry substantial risks. Consult qualified legal, tax, and accounting advisors and your treasury or finance team before entering into any hedging transaction.

Authoritative resources and further reading

• Alternative Reference Rates Committee (ARRC) — New York Fed: guidance on SOFR adoption.
• International Swaps and Derivatives Association (ISDA): standard documentation and protocol updates.
• Federal Reserve and U.S. Treasury publications on market infrastructure and benchmarks.
• Consumer Financial Protection Bureau (CFPB) resources on derivatives for small entities (general educational material).

For implementation help and scenario templates, work with experienced advisors and review our related FinHelp articles listed above for specific mortgage and hedging contexts.