Interest rate swaps vs. fixed-rate loans
A financial institution should evaluate two options when competing for borrowers who need fixed-rate funding:
- Providing a traditional fixed-rate loan
- Providing synthetically fixed-rate financing via a floating-rate loan and a pay-fixed swap
Each funding source offers the borrower a fixed, predictable interest rate for the term of the funding; however, a swap provides unique benefits to both the financial institution and the borrower. Below are six benefits to consider when evaluating the best solution to provide your borrower with long-term, fixed-rate financing.
|Benefit||Floating-rate loan + swap||Fixed-rate loan|
|Competitive advantage||Floating-rate loans with swaps allow the financial institution to be more competitive on term, amortization, and rate.||Limited by the financial institution’s appetite for term, amortization, and rate on the balance sheet.|
|Bilateral prepayment for the borrower||Floating-rate loans contain no prepayment penalties. While swaps do not have prepayment penalties, they do have make-whole provisions (two-way breakage). In a rising interest rate environment, the swap could be an asset to the borrower in the event of prepayment. In a falling interest rate environment, the swap could be a liability resulting in prepayment by the borrower.||Fixed-rate loans contain one-way prepayment penalties. Instead of owning the benefit of a rising interest rate environment, the borrower gives up this benefit in the event of a prepayment.|
|Flexibility||The borrower may determine how much of their debt should be fixed and floating. For example, the borrower may choose to fix 75% of their debt while leaving 25% floating under the same note.||The borrower must either fix or float the entire loan balance. If they want to achieve a percentage balance between fixed and floating, they will have two separate notes.|
|Fee income||The financial institution recognizes the swap fee income in the current period. They also recognize the loan origination fee over the life of the loan.||The financial institution does not generate fee income in the current period, only the loan origination fee over the life of the loan.|
|Broad product application||New term loans, lines of credit, construction loans, existing loans, and refinancings are all candidates for a floating-rate loan + swap solution.||Often, financial institutions will only offer fixed-rate financing on term loans.|
|Lock in future rates||
Swaps allow financial institutions to offer their borrowers rate locks well beyond 30-, 60-, or 90-days creating a competitive advantage for the financial institution and rate assurance for the borrower.
Typically, borrowers may be able to lock in their fixed rate 30- to 60-days before closing.
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Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.22-0071
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