Swap agreements: Mitigating the risk of rising interest rates

For owners and investors, rising interest rates present a very real risk. Interest rate swap agreements can help mitigate this risk. One key benefit of swaps is flexibility — they come in unlimited forms. Many swaps are based on standardized forms, but they can be custom-made to fit the parties’ specific financing needs. If handled properly, such arrangements can benefit all parties.

Ups and downs

An interest rate swap agreement is a type of derivative contract — independent of the underlying loan — that can be used to manage the risk of interest rate fluctuations and convert a borrower’s exposure from a variable rate to a fixed rate.

The most common type of interest rate swap is known as the “plain vanilla” swap. Here, a party (usually the lender) with fixed-rate liabilities agrees to “swap” interest payments with a party (the borrower) with variable-rate liabilities, such as a mortgage. Effectively, the lender agrees to make the borrower’s variable interest payments over a given period. In exchange, the borrower agrees to pay a fixed interest rate on the same “notional” amount.

The swap’s fixed rate equals the present value of expected future variable rates, customarily based on London Interbank Offered Rate (LIBOR) futures. The accuracy of this prediction determines whether the bank gains or loses money. The borrower usually pays no other incremental fees associated with the interest rate swap, and principal payments aren’t affected by interest rate swaps.

Typically, one party pays out each month (or quarter) for the difference between the variable and fixed rates. If the variable rate ends up rising above the fixed rate, the lender pays the borrower the difference.

Conversely, if the variable rate falls below the fixed rate, the borrower pays the lender the difference. Should the rates stay constant, neither party pays. When payments under the agreement are combined with the variable rate, the net amount paid by the borrower equals the fixed interest rate specified in the agreement.

Let’s say you have a variable rate loan with a current interest rate of 5%, and you enter a swap with your lender. If the floating interest rate falls to 4%, the rate on your loan also drops to 4%, and you must pay the lender 1% interest to account for the difference.

The result: You still end up paying a total of 5% interest. But if the floating rate climbs to 6%, thereby increasing your loan rate to 6%, the lender must pay you the 1% difference, effectively leaving your rate at 5%.

Coverage against losses

Lenders may require borrowers to secure their swap obligations with a mortgage subject to a title insurance policy. But such insurance typically excludes losses sustained by the insured lender as the result of a court ruling that the mortgage is invalid or unenforceable because the mortgage allows for interest rate changes. For that reason, title insurance policies associated with swap arrangements require endorsements (and additional premiums) that provide the lender coverage against such losses.

A direct obligation endorsement provides coverage to the lender if the insured mortgage is invalid or unenforceable or lacks priority as security for the repayment of the swap obligation. An additional interest endorsement provides coverage if the insured mortgage is invalid or unenforceable or lacks priority as security for repayment of the “additional interest.”

Both endorsements typically don’t cover changes to the swap agreement after the date of endorsement. Moreover, the stay, rejection or avoidance of the insured mortgage or any other remedy ordered by a court under bankruptcy or similar creditors’ rights laws isn’t covered.

In addition, the calculation by a court of the amount of the borrower’s swap obligation or additional interest isn’t covered. And last, but not least, the endorsements don’t cover the invalidity, unenforceability or lack of priority of the insured mortgage due to the failure to pay all applicable mortgage recording taxes, where applicable. This last exclusion would apply only in states where the government assesses a mortgage tax based on the loan amount.

Do your homework

If you’re concerned about fluctuating interest rates, bring in your financial professional. He or she can help you mitigate any risks.

© 2015