Just the Peaks

This newsletter at a glance 

  • Interest rate swaps are a useful tool when fixed rates aren’t so great

  • Investors enter into an exchange of interest payments with a lender

  • Is this arrangement right for you? Everest weighs the pros and cons

 

 

Interest rate swaps are enough to make your head spin!  

Let the veteran minds at Everest Equity explain it simply.

So many loans, so little time!

Once you dip your feet in the commercial pool, you start to grasp the difference between fixed and variable rate loans.

Borrowers who prefer safe, predictable, easy-to-calculate monthly payments gravitate toward the traditional fixed-rate mortgage, while variable options (such as a 5/1 ARMs) attract the risk-takers. Variable-rate mortgages are also a savvy choice for people who plan to pay off their loans quickly, as they tend to have lower rates at the start.

Naturally, there’s no clear ‘winner’ in the battle between fixed and variable rates.

Borrowers must examine the current market, interest rate trends, their own financial fitness, and other complex factors to determine the best option for their investment. But if you land on a variable-rate mortgage as your final choice, enter another difficult decision…

To swap or not to swap?

If you secure a variable loan, you’ll be watching interest rates for the life of it! In the case of a 30-year 5/1 ARM, your monthly payment is fixed for the first five years but will adjust every year thereafter according to the lender’s benchmarks (interest rate indexes).

 

The ebb and flow of these indexes are not only risky to borrowers, but also come with a large dose of stress and uncertainty—something most investors want to avoid.

This is where swap rates enter the conversation. Here’s how it works.

Rate Swap 101

Under a rate swap, the interest on a variable rate loan is turned into a fixed cost.

 

The lender offering the swap will use common interest rate indexes (SOFR, COFI, CMT) as a benchmark for this calculation. The transaction will include a schedule of assumed principal balances over the life of the loan. Then, the actual ‘swap’ happens through an exchange of interest payments between the borrower and the lender.

 

The holder of the loan will continue to pay their required monthly payment under the original variable-rate agreement. But once the swap is in effect, either the lender OR the borrower will owe the other party a payment each month. Since two separate transactions are taking place, the concept of a rate swap confuses many.

You still with us? Let’s keep going…

 

Who pays what under the swap?

 

During the months when the variable rate is higher than the swap rate, the lender will reimburse the borrower. But when variable rates fall lower than the swap rate, the borrower foots the bill. The paid amount is calculated as follows:

The difference in rate

X

Assumed principal balance for that month

The result? Borrowers wind up paying a fixed rate each month (despite holding a variable-rate loan). In the lending world, this arrangement is also referred to as a synthetic fixed-rate loan.

There are some other factors that might impact money exchanged, but in a nutshell, this is the story of the infamous rate swap!

What are the advantages of a swap?

  • It helps you manage cash flow. Knowing how much you’ll pay each month makes it easier to budget, plan, and maintain your investment property in the long run.

  • It can save you money. In most cases, a variable-rate loan with the addition of a swap costs less than a traditional fixed-rate mortgage (emphasis on MOST).

  • You have more choice of lenders. A synthetic fixed-rate loan may be your only affordable option (or the only option at all), which means more borrowing opportunities.

  • Possible prepayment savings. While certain prepayment penalties exist under a fixed-rate mortgage, they don’t apply to swaps (although a swap termination payment may apply). Many argue that the risk is worth it.  

  • You can lock in a future rate. If current bank rates aren’t great, you can opt for a variable loan and swap at a later date (when the numbers are in your favor!).

 

  • The options are endless.  A rate swap doesn’t have to apply to the entire mortgage amount. Instead, you can apply for a rate swap for just a portion of the loan (the remainder is subject to the floating rate). It’s very flexible!

 

Are there any downsides to a swap?

  • You may end up paying more. During times of economic turmoil, the swap may prove disadvantageous (and this can be very hard to predict).

  • Greater damage in event of default. Early termination settlements are highly subjective and, in some cases, abusive toward the borrower.

  • Documentation is very complicated. Borrowers who fail to do their due diligence may end up with an agreement full of costly traps. It’s best to have an experienced loan officer or attorney at your side.

  • Other hidden risks. Rate swaps are complicated, and so are their downsides! Speak with someone you trust to ensure you fully understand the scope of the transaction.

Everest says: swap or not, we lock in your lowest rate

Everest Equity

Top Commercial Loan

Originator Since 2004

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