Why to choose a swap loan over a fixed rate loan - by Tim Weiss and Mairead Anderson

 

 

Most banks offer borrowers fixed rate financing in the form of a fixed rate loan or a variable rate loan combined with a fixed rate swap. Two important factors need to be considered by borrowers when deciding which form of the financing to accept. A fixed rate loan is more simple and easier to understand for the borrower since the rate is quoted as a spread over the comparable Treasury rate for the term of the loan. A swap involves a loan that is usually quoted as a spread over the 1-month LIBOR rate and converted to fixed with a fixed rate swap. While the indication for a fixed rate using a swap/loan combination often lacks transparency for the borrower, the use of a consultant can provide that transparency and protection for the borrower. The use of swaps also come with additional documentation especially post Dodd Frank legislation and again, a consultant provides the expertise and support needed to walk through that process. The important considerations when comparing the alternatives are pricing and prepayment terms.

Pricing of Fixed Rate Loans Compared to Fixed Rate Swaps: Banks typically price fixed rate loans based on the Federal Home Loan Bank, (FHLB) rate for the same term. The FHLB rates are posted online for Boston at www.fhlbboston.com. The FHLB uses the swap market to quote their rates which are considered the cost of funds for the bank. Both the FHLB and the bank have costs imbedded in their fixed rates, so the borrower is left with having to pay both the funding provider and the bank a margin. Pricing fixed rate loans based on FHLB rates usually results in a higher fixed rate for the borrower. For example, a 10-year fixed rate loan based on the FHLB rate is typically 75 basis points higher than a loan/swap offering. On a pure pricing basis a borrower should factor in the price advantage available by hedging with a loan/swap combination.

Prepayment Comparison: By hedging with a loan/swap combination, borrowers need to be aware of the advantage that is available. Swaps come with prepayment terms that are known as “two-way” prepayment terms while a fixed rate loan offered by a bank are only one-way. In the event of a prepayment with the two-way prepayment terms the borrower would have to pay an unwind cost, or penalty should rates fall but if rates rise the borrower would benefit by a gain owed to them by the bank. With a fixed rate loan the borrower is only exposed to a potential penalty and would never receive a gain on a prepayment. 

Tim Weiss is a sales executive and Mairead Anderson is an intern at Harbor Derivatives, Scituate, Mass.