Unlike the traditional loan payment you would make on a fixed rate loan (e.g., $2,000 per month for 10 years), a swap payment has a fixed interest rate. However, the monthly payments differ, each based on the number of days in the month. On the $2,000 per month example, a swap payment would be $2,013 in January, $1,904 in February, and so on. Months with 30 days would be approximately $1,992. The 12-month average payment would be $2,000.
Beware of Penalties
Since a swap contract is set for a specific time period, a prepayment “breakage” penalty comes into effect if it’s broken before term. This is important to know since this type of financial product may not be as flexible as many think. Most borrowers want the longest fix-rate term possible to lock in the rate. But a lot can happen in 10 years, so you have to be even more careful when you’re entering into a long-term swap deal.
A swap is great if you don’t need to alter it during the term. However, it’s important to remember that unforeseen life events do happen. Consider that a divorce could force a sale, or a partnership may dissolve, both of which are unfortunate but common events that lead to the need for breaking a swap contract.
One way to strategically offset the risk of a long-term swap is to break the 10-year-term loan into two five-year swap contracts. In reality, you only have a five-year fixed rate. At the end of the first five-year period, you simply re-swap your remaining term loan for another five years. Alternatively, depending on the circumstances, you may also choose to refinance the loan with another lender, this time with no prepayment or breakage fee.
Currently, we’re seeing interest rates near historical lows, and this has many concerned that in five years when their swap re-prices the rate will be much higher. In fact, there exists a delicate balance between the optimal interest rate and flexibility of options. Consider that a five-year swap contract is priced approximately 1 percent lower than the 10-year equivalent swap today.
For example, if you were able to get a 10-year-term loan for $2 million with a 10-year swap contract at 6.5 percent, the total outlay over the 10-year period would be approximately $1,620,480. If you decided to get that same 10-year-term loan with two five-year swap contracts, you would only pay a 5.5 percent interest rate for the first five years. The rate would have to rise to 7.5 percent in the second five-year period before the borrower would pay the same as if he did the 10-year swap to begin with. And he would have the added benefit of being able to sell the property or refinance it at the end of the initial five-year period of the loan.
Consider All Your Options
Most financial institutions tell borrowers swap contracts can be assumed and, in theory, this may be true. But in practical application, it’s often difficult to achieve. In most cases, the adjustable-rate loan underneath the swap contract can certainly be assumed. However, it’s ultimately often up to the discretion of the financial institution whether to allow the assumption of the swap.
In fact, there’s typically language in the swap-contract documentation that provides the financial institution with “outs” if the assumption doesn’t work to its financial advantage. In practical application, I’ve not yet witnessed a financial institution allow for a loan assumption when a swap contract is in place, because lending intuitions typically prefer the seller of the property to pay the swap-breakage fee.
The amount of the breakage fee is onerous and generally becomes cost-prohibitive for the transaction at hand. I’m certain lenders would refute my previous comment, but if there isn’t some financial advantage for doing so, my experience is that an assumption will not be approved.
Should You Swap?
So why are lenders using swap contracts as a mechanism to fix rates for borrowers? The simple answer is they make more money on the loan by hedging and placing this side bet. It would be much easier for a borrower to sign less paperwork and not get dragged into yet another financial product that’s difficult to fully understand, but the easiest solution is not always the one that’s readily available.
If you’re considering entering into a swap contract to fix the interest rate on a variable-rate loan, it’s prudent to have a commercial-mortgage professional along with your attorney advise you during the process and take a close look at the documents. A swap can be useful financial tool; however, the key to executing a loan with a swap, like many other things in life, is asking many questions to the parties involved so you really know what you’re getting into.
David Zorich is a senior vice president at The BSC Group, where he provides mortgage brokerage and financial-consulting solutions to commercial real estate owners nationwide. He can be reached at 949.232.5997; e-mail email@example.com; visit www.thebscgroup.com .