What Are Interest Rate Swaps and How Do They Work for Commercial Borrowers?

Interest rate swaps are common hedging instruments for businesses that borrow on floating rates or that want to alter their interest-rate profile without refinancing underlying loans. In plain terms, a swap lets a borrower trade the interest-payment pattern of one obligation for another: usually swapping a floating-rate obligation (e.g., SOFR-based) for a fixed payment stream, or vice versa. The swap’s economics are determined on a notional principal amount (which is never exchanged) and settled by netting the two legs of the contract.

Below I explain how swaps work in practice, what commercial borrowers must check before entering one, common uses and pitfalls, and the operational, accounting, and legal items that matter most.

How a basic interest rate swap is structured

• Notional principal: The reference amount used to calculate interest payments. It’s a bookkeeping amount only; the principal is not exchanged.
• Fixed leg: One party agrees to pay a fixed interest rate on the notional (quoted as an annualized percentage, with a specified day-count convention and payment frequency).
• Floating leg: The other party pays a variable rate tied to a benchmark (in USD markets today, typically a version of SOFR). The floating rate resets on scheduled reset dates.
• Net settlement: On each payment date the two legs are netted and only the difference is paid by the party that owes more.
• Documentation: Trades are usually executed under an ISDA Master Agreement with a Credit Support Annex (CSA) for collateral and margining terms.

Key operational details include payment frequency (quarterly, semiannual), day-count convention (e.g., ACT/360 vs ACT/365), business-day conventions, and whether the swap is physically settled or cash-settled (most interest-rate swaps are cash-settled).

Authoritative introductions to swaps can be found at the Federal Reserve and CME Group educational pages (see Federal Reserve; CME Group).

Why commercial borrowers use swaps

• Convert floating-rate debt to fixed payments to stabilize cash flow and budgeting.
• Convert fixed-rate exposure to floating to benefit if rates fall (less common for borrowers but used by some corporate treasury teams).
• Manage mismatch between loan terms and project cash flows (duration matching).
• Hedge basis risk between different floating benchmarks (basis swaps), or to synthetically extend or shorten debt maturities.

For many commercial borrowers, locking predictable interest costs enables better capital planning and loan covenant management. For example, a company with a five-year project financed by a floating-rate loan might swap to a fixed rate to lock predictable debt service through the project’s revenue horizon.

Example: simple cash-flow illustration

Assume a borrower has a $10 million floating-rate loan paying SOFR + 2% (paid quarterly). They want to lock rates and enter a 5-year pay-fixed swap at a 4.25% fixed rate on $10 million notional.

• Floating loan cost (approximate): SOFR + 200 bps (changes each reset).
• Swap result: Borrower pays the swap fixed leg (4.25%) and receives floating (SOFR) from the counterparty. Net effect on the borrower’s loan:
• Original loan payment (floating) remains to the bank: SOFR + 200 bps.
• Swap receipts/payments net to: pay 4.25% — receive SOFR = net pay 4.25% — SOFR.
• Combining: (SOFR + 200) + (4.25 — SOFR) = 4.25 + 200 bps = 6.25% effective rate on the notional (economically equivalent to converting loan into a fixed 6.25% borrowing cost).

That simple algebra shows swaps don’t magically reduce your true economic cost unless the fixed rate on the swap plus any spread adjustments is lower than an alternative fixed financing. Swaps are about shifting the type of interest exposure, not creating free value.

Benchmark transition and current practice (SOFR vs LIBOR)

LIBOR’s phase-out after 2021 means most new USD floating legs use SOFR or a SOFR-based tenor-rate with credit/funding spread adjustments. Legacy contracts referencing LIBOR still exist but include fallback provisions. When negotiating or reviewing a swap, confirm the floating index and fallbacks (ISDA managed a global transition with published fallback language). See ISDA and the Federal Reserve for guidance on the LIBOR transition.

Counterparty risk, collateral, and margining

A swap exposes each party to the other’s credit risk. To mitigate this, counterparties typically:

• Trade under an ISDA Master Agreement with a Credit Support Annex (CSA).
• Post collateral or variation margin when positions move out of the agreed thresholds.
• Use clearing via a central counterparty (CCP) for some standardized swaps, which reduces bilateral credit exposure but requires initial and variation margin.

Commercial borrowers should confirm whether their bank requires posting collateral, whether margin calls could impact liquidity, and how collateral is rehypothecated.

Accounting and tax considerations

Accounting: Under U.S. GAAP, hedge accounting is governed by ASC 815. Only properly documented and effective hedges may qualify to defer volatility in earnings; otherwise, changes in the swap’s fair value hit earnings. Borrowers should involve accounting early to determine whether they intend to designate the swap as a cash-flow hedge, fair-value hedge, or not hedge-accounted.

Tax: Tax rules for derivatives can be complex. Treatment depends on whether the instrument qualifies as a hedging transaction under tax rules, the entity’s tax status, and elections made on tax returns. Always consult a tax advisor to determine whether swap payments are deductible, whether mark-to-market rules apply, or whether special reporting is required (see IRS guidance and consult counsel).

Practical checklist before entering a swap (commercial borrower perspective)

1. Align the swap with the loan documents: Confirm permissibility under the credit agreement and ensure no events of default are triggered.
2. Confirm benchmark and fallback language: Make sure the floating index is appropriate (SOFR vs legacy LIBOR) and fallback events are documented.
3. Negotiate ISDA/CSA terms: Understand margining, thresholds, and eligible collateral to avoid unexpected liquidity needs.
4. Review accounting impact: Coordinate with your CFO/controller to confirm hedge accounting eligibility and documentation requirements under ASC 815.
5. Review tax treatment: Coordinate with tax counsel to vet deductions and reporting requirements.
6. Model cash flows and stress scenarios: Run scenarios for rate spikes, basis widening, and early termination costs.
7. Understand breakage and termination: Request the methodology for early termination valuation and potential termination costs.
8. Compare alternatives: Evaluate caps, floors, collars, or refinancing—sometimes a rate cap plus fee is preferable to a swap if you want upside participation.

Common mistakes and misconceptions

• Thinking swaps eliminate all risk. They change the form of risk (interest-rate risk becomes counterparty and basis risk).
• Overlooking threshold and margin terms. Unexpected margin calls can create liquidity stress.
• Failing to confirm loan-document compatibility. Many credit agreements require lender consent or contain anti-derivative covenants.
• Neglecting accounting and tax consequences, which can introduce earnings volatility or different tax outcomes than expected.

Variations useful to commercial borrowers

• Fixed-for-floating (plain vanilla) swap: Most common for locking fixed payments.
• Basis swap: Exchanges floating rates referenced to two different benchmarks (e.g., LIBOR vs SOFR) to manage basis risk.
• Swaption: Option to enter a swap in the future—useful when you want optionality on hedging timing.
• Zero-cost collars (combining caps and floors): Provide a capped ceiling on floating costs while keeping some upside if rates fall.

For borrowing against real estate or long-term projects, see our related guides on Interest Rate Swap Basics for Large Commercial Mortgages and practical hedging options in Interest Rate Hedging for Mortgages: Caps, Swaps, and Practical Basics. If your loan documentation includes both fixed and floating clauses, also review our piece on Fixed vs Floating Rate Clauses in Commercial Loan Agreements.

When swaps make sense—and when to reconsider

Use a swap when:

• You have material floating-rate exposure that creates budgeting or covenant risk.
• The cost of the swap plus any credit costs is acceptable relative to available fixed-rate financing.
• You can manage collateral and margining requirements.

Reconsider if:

• Your exposure is small and the administrative/credit overhead outweighs the benefit.
• You expect rates to fall significantly and want to retain upside (consider caps or collars instead).
• Your loan docs or corporate policy prohibit derivatives or require onerous collateral.

Closing notes and resources

Interest rate swaps are powerful tools when used thoughtfully: they convert interest exposure rather than eliminate it, and they create new operational and credit considerations that must be managed. In my practice helping commercial borrowers, the most successful outcomes come from early coordination among treasury, legal, accounting, and tax teams, and from modeling realistic adverse-rate scenarios.

Authoritative resources and further reading:

• Federal Reserve: materials on derivatives and market functioning (https://www.federalreserve.gov)
• ISDA: documentation and guidance on swaps and the LIBOR transition (https://www.isda.org)
• CME Group: educational content on interest-rate swaps and clearing (https://www.cmegroup.com)
• Consumer Financial Protection Bureau: consumer-level explanation of swaps and risks (https://www.consumerfinance.gov)

Professional disclaimer: This content is for educational purposes only and does not constitute financial, legal, or tax advice. Before entering any derivative or hedging transaction, consult qualified legal, tax, and financial advisors.