How do interest rate swaps affect commercial loan refinancing?

Interest rate swaps can materially change the economics and timing of a commercial loan refinance. For businesses with variable-rate debt, a swap can lock interest costs (converting floating to fixed), reduce refinancing urgency, and improve predictability for cash flow and covenants. Conversely, swaps create counterparty exposure, potential termination costs, and basis risk that must be evaluated alongside refinancing fees and market conditions.

In my 15 years advising middle-market borrowers and CFOs, I’ve seen swaps allow a company to extend a refinancing window by 6–18 months or to negotiate better fixed-rate terms at refinance because lenders see reduced rate risk. But swaps are not free: the present value of future swap payments, credit support requirements, and any breakage fee must be weighed against savings. Below I explain how swaps influence refinancing decisions, how to model outcomes, and practical steps to use swaps responsibly.

Why borrowers use swaps when refinancing

  • Locking expected cash costs: A swap that converts LIBOR- or SOFR-linked floating payments into a fixed rate lets a borrower freeze interest expense assumptions and avoid the need to refinance immediately if market rates spike (New York Fed: SOFR information, https://www.newyorkfed.org/markets/reference-rates/sofr).
  • Creating optionality: A borrower can retain a variable-rate loan while synthetically fixing the cash flows via a swap—this may be faster or cheaper than replacing the whole loan at an unfavorable timestamp.
  • Improving lender perception: Some lenders prefer to see reduced interest-rate exposure in a borrower’s financial model, which can improve refinance pricing or covenant terms.

Authoritative market context: the swaps market is deep and standardized through ISDA agreements (ISDA, https://www.isda.org), and LIBOR has largely been replaced by SOFR as the preferred secured overnight benchmark (FCA and New York Fed guidance, https://www.fca.org.uk, https://www.newyorkfed.org).

The main ways a swap affects a refinancing outcome

  1. Cash flow stability and budgeting

A fixed-for-floating swap stabilizes interest payments. Example: a $5 million commercial loan tied to SOFR + 2.5% with a current SOFR of 4.0% results in a floating rate of 6.5%. If you enter a swap to pay a fixed 5.5% and receive floating, your net cost becomes 5.5% (plus any basis difference). During a rate spike, the swap prevents payment surprises—helpful for meeting debt-service covenants and convincing lenders to offer better terms.

  1. Timing and urgency to refinance

Without a swap, rising market rates can force borrowers to refinance sooner to lock in acceptable fixed rates. A swap can buy time: you still owe the same loan but have limited exposure to further rate increases. That optionality can let you wait for better credit-market conditions or to improve leverage metrics before committing to a new loan.

  1. Economics: direct savings vs. costs

Model both sides. Typical cost components to include:

  • Swap fixed rate vs. expected future loan fixed rate
  • Upfront or recurring dealer fees
  • Mark-to-market (MTM) exposure and credit support (collateral) under the ISDA and credit support annex (CSA)
  • Breakage or termination fees if you unwind the swap early
  • Tax considerations for hedge accounting (consult CPA)

Quick scenario: you have a $2M loan for 5 years. If a swap fixes your rate at 4.00% vs. expected refinance fixed of 5.25%, you might project annual interest savings of 1.25% * $2M = $25,000 (ignoring compounding and fees). If the swap requires posting collateral of $30,000 initially and charges a dealer spread that reduces savings by $5,000/year, the net benefit could shrink or disappear—run a present-value analysis using a discount rate that reflects your cost of capital.

  1. Credit and counterparty risk

A swap replaces interest-rate risk with counterparty credit exposure: if the bank on the other side defaults, your hedge may be impaired. Post-2008 reforms and regulatory standards require documentation (ISDA) and standardized clearing for many contracts, but bilateral swaps still carry credit risk (ISDA and federal regulators—https://www.isda.org, https://www.federalreserve.gov).

  1. Basis risk and benchmark mismatch

Most commercial loans now reference SOFR or a bank’s internal replacement rate rather than LIBOR. If your loan uses a different benchmark or includes vendor margins that move differently than the swap’s reference rate, you face basis risk: the swap’s payments won’t perfectly offset the loan. Carefully confirm the loan’s rate language and fallback provisions; mismatches can produce residual exposure.

Practical steps to analyze a swap vs. refinance

  1. Run a side-by-side PV (present value) model
  • Estimate future loan payments under: current variable structure, a direct refinance into a fixed-rate loan, and the synthetic fixed outcome using a swap plus the existing loan.
  • Discount cash flows at your weighted-average cost of capital or a risk-free curve + spread.
  1. Include collateral and liquidity impacts
  • Swaps can trigger collateral posting if MTM swings negative. That reduces available liquidity and could affect covenant compliance during stress.
  1. Evaluate termination scenarios
  • If you refinance the underlying loan, you’ll often terminate the swap. Termination value can be positive or negative and is determined by the market’s view of forward rates at that time. Ask the dealer for forward breakage estimates under plausible rate paths.
  1. Confirm legal and accounting treatment
  • Ensure documentation (ISDA, CSA) is in place and consult your accountant about hedge accounting and tax treatment, because favorable accounting treatment can lower P&L volatility.
  1. Shop for competitive swap pricing
  • Dealers and banks price swaps differently. Solicit multiple quotes and compare the all-in fixed rate, dealer spread, and collateral terms.

Real-world examples and red flags

Example 1 — Tactical delay of refinancing

A tenant improvement lender with a $3M variable loan faced rising yields. Instead of refinancing immediately at a poor fixed rate, they entered a 2-year swap fixing the rate. That gave the company time to complete a lease-up, improve debt-service metrics, and refinance at a 1% lower fixed rate later. The swap’s net cost was small versus the improved refinance terms.

Example 2 — Unwinding pain

A manufacturing client entered a swap and later sold the property subject to the loan. Early termination triggered a negative MTM on the swap. The client had not modeled the worst-case termination cost and had to pay a significant breakage fee. Lesson: always model sale or prepayment scenarios.

Red flags before using a swap:

  • Unclear loan benchmark and fallback language
  • Insufficient liquidity to post collateral if rates move
  • Lack of multiple dealer quotes
  • No documented exit or termination plan

Accounting, tax, and regulatory considerations

  • Swap documentation should follow ISDA standards; read the credit support annex carefully.
  • Hedge accounting under U.S. GAAP or IFRS requires strict documentation and effectiveness testing—consult a CPA. Improperly documented hedges can lead to earnings volatility (FASB guidance).
  • Regulatory changes since LIBOR’s phaseout mean many legacy contracts were amended for SOFR; verify your loan’s fallback language (FCA and New York Fed guidance).

How to present swaps to lenders during refinance negotiations

  • Show pro forma cash flows with and without the swap to demonstrate reduced rate volatility.
  • Provide ISDA/CSA documentation and evidence of counterparty credit (or clearing arrangements) to reassure lenders about counterparty risk mitigation.
  • Use swap hedge results as part of your covenant compliance plan—demonstrating stabilized interest coverage ratios can improve negotiating leverage.

Useful resources and further reading

For practical articles on related refinancing topics on FinHelp, see:

Common mistakes to avoid

  • Treating swaps as free insurance: they shift, not eliminate, risk.
  • Ignoring basis and operational mismatches between loan language and swap terms.
  • Failing to model termination or collateral requirements in stress scenarios.

Bottom line

Interest rate swaps are a powerful tool to influence the timing, cost, and risk profile of commercial loan refinancing. When used correctly, they can deliver significant cash-flow stability and allow borrowers to time market entry more advantageously. But they add credit exposure, potential liquidity needs, and termination risk. Always run a rigorous PV model, get multiple dealer quotes, confirm legal and accounting treatments, and consult tax and finance professionals before executing a swap.

Professional disclaimer: This article is educational and based on general market practice and my 15 years of advisory experience. It is not individualized financial, tax, or legal advice. Consult your financial advisor, accountant, and legal counsel before entering into derivatives or refinancing transactions.