Swaps 101: How Interest Rate Swaps Can Strengthen Your Borrowing Strategy
Interest rate uncertainty has put a lot of business owners on edge. When funding an expansion, managing seasonal cash flow or just trying to plan ahead, the uncertainty of floating loan rates can make long-term budgeting feel like a guessing game. If that sounds familiar, an interest rate swap might be a tool worth exploring.
Swaps aren’t loans or a new way to borrow. They’re interest rate management tools. Used in the right circumstances, they can help a business create more predictability and potentially reduce financing costs.
What is an interest rate swap?
A swap isn’t a source of capital or a loan alternative. It simply changes how you manage the interest on debt you already have.
At its core, an interest rate swap is an agreement between two parties to exchange future interest payments. Most commonly, a business that has a loan with a floating rate (often tied to SOFR or another benchmark) uses a swap to lock in a fixed rate. This creates what’s known as a synthetic fixed rate.
That fixed rate might be more attractive than a traditional fixed-rate loan, or it might be part of a strategy to hedge against rising interest costs. And swaps are highly customizable. You can fix just a portion of your debt, schedule the swap to start in the future, or apply it to only part of your loan term.
How does a swap work?
Let’s walk through a simplified example.
Say your company has a $2 million loan with a floating rate, such as SOFR plus 1 percent. If the current SOFR rate is 5 percent, your interest rate today is 6 percent.
Now suppose you enter into a swap with a financial institution to pay a fixed rate of 5 percent. Under the terms of the swap, you’ll still make your loan payments to your lender, but you’ll also exchange interest payments with the counterparty. They pay you the floating rate (6 percent percent), and you pay them the fixed rate (5 percent percent).
In this case, you receive 6 percent through the swap and pay 5 percent, which nets out to a 1 percent gain. You still owe 6 percent on your loan, but the 1 percent you gain through the swap brings your effective cost back down to 5 percent. Even though your actual loan rate is floating, you have effectively locked in a 5 percent interest cost.
If SOFR rises further, your floating loan payment would go up, but so would the amount the counterparty pays you. If SOFR drops, you no longer benefit from the lower rate, but you gain stability. That can be valuable for budgeting and forecasting.
Who uses swaps?
Swaps are typically used by commercial and corporate borrowers, ranging from large public companies to small and mid-sized businesses. To participate, you generally need to qualify as an Eligible Contract Participant (ECP), which is a regulatory term based on business size, assets or sophistication.
Your banker or advisor can help determine if you meet the requirements and whether a swap makes sense for your business.
When does a swap make sense?
Interest rate swaps can be a good fit when:
- You’re concerned about future rate increases and want more certainty in your interest costs
- You’re planning for long-term investments and need stable payments for better forecasting
- You want to fix the rate on just a portion of your debt to balance flexibility and risk
- You’re borrowing $1 million or more in term debt and want alternatives to refinancing
Swaps are especially helpful when market conditions make fixed-rate loans expensive or hard to come by.
What should I consider before entering a swap?
Like any financial tool, swaps involve trade-offs. Some things to think through:
- Risk tolerance: Are you comfortable locking in a fixed rate if floating rates fall?
- Loan terms: Swaps typically don’t cover the variable “spread” or markup over the benchmark rate.
- Prepayment: Exiting a swap early could carry a cost, especially if interest rates move in your favor.
- Market spread: The difference between fixed and floating rates at the time you enter the swap will affect your outcome.
It’s not a one-size-fits-all decision, and modeling the impact under different scenarios can help clarify the risk and reward.
Talk with a financial advisor about how swaps work in the context of your full financial picture. Together, you can evaluate the options and decide if a swap is the right fit for your business.
Walt Cherry is a managing director of capital markets based at Pinnacle’s Riverwood office in Atlanta. He can be reached by phone at (470) 990-8471 and by email at Walt.Cherry@pnfp.com.
