Overview

Interest rate swaps are over-the-counter (OTC) derivative contracts in which two counterparties exchange periodic interest payments on a notional principal. One side typically pays a fixed rate; the other pays a floating rate tied to a benchmark (today usually SOFR in the U.S.). Swaps don’t transfer loan principal — they alter the interest profile of existing debt to hedge volatility or manage financial strategy (ARRC/NY Fed: https://www.newyorkfed.org/arrc).

How a swap works (simple example)

  • Situation: A commercial borrower has a $10 million variable-rate loan tied to a floating benchmark and wants stable payments.
  • Swap: The borrower enters a payer-fixed swap with a bank. The borrower pays a fixed rate on the $10M notional to the bank and receives floating-rate payments from the bank. Netting occurs, so only the difference is exchanged.
  • Result: Economically, the borrower converts floating-rate debt into fixed-rate debt without repaying the loan principal.

Real-world note: LIBOR has been largely phased out; most U.S. swaps now reference SOFR or SOFR-based rates instead of LIBOR (ARRC/NY Fed guidance).

Why commercial borrowers use swaps

  • Hedge interest-rate risk: Lock predictable interest costs when you expect rates to rise.
  • Cash-flow planning: Fixed payments simplify budgeting and debt service coverage analyses.
  • Balance-sheet management: Adjust interest-rate mix without refinancing the underlying loan.
  • Customization: Swap terms (tenor, payment frequency) can be tailored to match loan maturity and cash flows.

Costs, risks and trade-offs

  • Counterparty (credit) risk: If the swap counterparty defaults, you may lose the hedge; many transactions use collateral or central clearing to reduce this risk (CFTC/ISDA guidance: https://www.isda.org, https://www.cftc.gov).
  • Termination/exit costs: Closing or selling a swap early can trigger market-value payments or breakage fees.
  • Basis risk: If your loan indexes to a different benchmark or has floors/ceilings, the hedge may be imperfect (see internal guidance on interest-rate floors: https://finhelp.io/glossary/understanding-interest-rate-floors-and-ceilings-in-commercial-loans/).
  • Opportunity cost: If rates fall, a fixed-rate payer may pay more than prevailing market rates.
  • Legal/operational complexity: Swaps rely on documentation (ISDA Master Agreements) and require accounting and tax treatment (consult a tax advisor).

Comparison: Swap vs. refinancing or cap

  • Refinancing replaces the loan; a swap changes the interest profile without altering principal or covenants.
  • Interest rate caps provide protection against rising rates with limited upside cost, but caps require premium payments and may be more costly for long tenors.

Practical steps for commercial borrowers

  1. Define objective: Are you hedging cash flows, protecting covenants, or speculating? Clear goals guide the structure and tenor.
  2. Match tenor and cash flows: Align swap payments with loan payment dates and maturity to reduce basis risk.
  3. Price and credit terms: Request quotes, compare breakage/termination clauses, and evaluate collateral agreements.
  4. Document and tax review: Use standard ISDA documentation and get legal and tax review; swaps have specific accounting and tax implications (consult CPA or tax counsel).
  5. Monitor and manage: Treat swaps as active positions—review counterparty credit, collateral calls, and mark-to-market exposure.

Professional insight

In my work advising middle-market borrowers, the most successful hedge strategies are simple, time-aligned, and sized to cover the borrower’s core exposure rather than the full notional of a project. Over-hedging creates unnecessary costs and operational complexity.

Internal resources

Quick checklist before signing

  • Confirm benchmark (SOFR vs legacy LIBOR) and fallback language.
  • Check collateral, margin, and credit-support annex terms.
  • Estimate early termination cost scenarios.
  • Get tax and accounting sign-off.

Authoritative sources and further reading

Disclaimer

This article is educational and not individualized financial, legal, or tax advice. Consult a qualified CPA, attorney, or derivatives professional before executing swap transactions.