Although interest rate swaps have been around for years, they’re attracting more attention from farmers these days as interest rates hover near zero.
Interest rate swaps are derivatives that allow a floating, or variable, rate to be converted to a fixed one – or vice versa. You’re swapping interest rates with another party. One party gets the risk protection of a fixed rate, while the other receives the exposure to potential profit from a floating rate.
Interest rate swaps are generally based on the benchmark LIBOR rate.
An interest rate swap should be viewed as an insurance policy or hedging tool to provide you with certainty about your future borrowing costs. It is a powerful but complex product.
Consider the two main advantages of an interest rate swap, says Eric Donovan, a managing director and head of FX and interest rates for Stone X Group:
1. An interest rate swap can convert the terms of your operating line of credit to a fixed rate. Lenders typically only offer these seasonal loans with floating interest rates. But an interest rate swap can save you money in allowing you to convert your balance to a fixed rate. If interest rates rise, you’re protected from higher payments. You will, however, pay a monthly premium for the protection.
2. Swaps give you timing flexibility. With an interest rate swap, it’s possible to lock in a lower rate on, for example, a 15-year, fixed-rate loan when you decide to, rather than when you close the loan.
Donovan offers a few caveats about interest rate swaps.
“Arranging an interest rate swap on a loan balance of less than $1 million typically isn’t worth the trouble and expense,” he says. “The sweet spot for worthwhile savings is between $5 million and $10 million or more.”
Further, if you secure a fixed-rate contract with an interest rate swap, will you be able to pay the margin, or difference, if interest rates drop significantly?
In addition, when you secure a rate with an interest rate swap, it’s final. “If you’ve locked in a rate at 3.5%, and the market interest rate drops to 1%, there’s no getting out,” he says. “You’ll have to pay the margin, which can be expensive.”
Many banks will include an option for an interest rate swap alongside your loan but if you decide to leave that bank, exercising that option becomes very expensive. A third-party arrangement might be more flexible and affordable.
Because these derivatives aren’t understood by a lot of businesses, make sure you are familiar with how and when they work, as well as the potential exposure of early termination. Consult with a trusted adviser who has the resources to help you secure a worthwhile benefit from an interest rate swap.
