A Practical Overview for Business Owners
When a business takes on debt, one of the biggest variables that can affect a business’s cash flow is the interest rate on the loan. If the rate is fixed, they know exactly what they’ll pay each month. If it’s a floating (or variable) rate, their payment will change as market rates move. An Interest Rate Swap is a tool that businesses can use to manage the inherent risk tied to the rate they have for their loan. It doesn’t change the terms of the loan itself. Instead, it works alongside the loan to change how the borrower’s interest costs behave over time.
What is an Interest Rate Swap?
An Interest Rate Swap is a contract between two parties where they agree to exchange interest payments based on a notional amount (a number used only to calculate payments, meaning no one actually lends or receives that principal in the swap). Swaps are privately negotiated (not traded on an exchange) and are generally regulated by the SEC and CFTC. Swap agreements are documented under a standardized legal contract called an ISDA Master Agreement.
In the most common type of swap:
- One party pays a fixed interest rate; and
- The other pays a floating rate tied to a benchmark such as SOFR
Example:
Two companies each borrow $5,000,000 from their respective lenders, but their loan rate options don’t match their preferences:
- Party A is offered either 11.00% fixed or SOFR + 2.00% floating and prefers fixed but not at 11.00%.
- Party B is offered 7.30% fixed but prefers floating.
They enter a swap through an ISDA Master Agreement:
- Party A pays a fixed 7.30%.
- Party B pays SOFR +2.00%.
The swap aligns each party with its desired rate structure in the background while each continues to pay its lender directly.
Note that each party calculates its interest payment using the agreed-upon rate (fixed or variable) and the notional principal amount. Only the net difference is paid, meaning money doesn’t move back and forth unnecessarily.
If Party A owes $300,000 based on its fixed rate and Party B owes $350,000 based on its floating rate, then instead of exchanging both amounts, Party B simply pays Party A the $50,000 difference.
Why Do Businesses Use Interest Rate Swaps?
The primary purpose of a swap is to manage risk. If a borrower has a floating-rate loan and worries about rising rates, a swap can help them lock in a fixed rate and create budget certainty. If a borrower has a fixed-rate loan and believe rates are likely to fall, a swap can allow them to benefit from lower market rates.
For many middle-market companies, swaps can:
- Stabilize debt service payments;
- Protect margins from market swings; and
- Support long-term planning and budgeting.
Where Swaps Require Caution
Swaps can be very useful, but they’re not always a fit. Consider the potential downsides:
- Early termination costs can be significant if you break a swap before it ends.
- Refinancing or paying off your loan does not automatically end the swap.
- Swaps require monitoring and periodic valuations.
- The structure can be more complex than a straightforward fixed-rate loan.
Key Takeaway
Interest Rate Swaps can be effective tools for managing interest rate risk and creating budget stability, but they require thoughtful planning. A swap can help stabilize financing costs, but only if the structure matches business strategy and is fully understood. The best results occur when a borrower’s banker, attorney, and financial advisor work together to ensure the structure aligns with financial goals and risk tolerance.
Kelly Callahan of Liff, Walsh & Simmons is an associate attorney in the Banking & Finance Law, Real Estate Law, and Business Counseling, Contracts & Transactions Law practices. Her expertise spans across a diverse range of practice areas including matters involving complex commercial loans and title matters, real estate transactions, commercial leasing, mergers and acquisitions, contract negotiations, and general business counseling.
Our team of Banking & Finance Law attorneys at Liff, Walsh & Simmons has a proven track record of representing both lenders and borrowers in a wide variety of financing transactions. Our clients benefit from our proactive approach built on years of experience in structuring, negotiating, closing, and even restructuring credit facilities when necessary. Please contact Liff, Walsh & Simmons at 410-266-9500 to schedule a consultation.
