An interest rate swap is a derivative contract in which two parties agree to exchange interest rate cash flows for a specified period. In the plain vanilla structure the borrower pays a fixed rate and receives SOFR, which converts a floating-rate loan into a synthetic fixed rate equal to the swap rate plus the loan spread.
How does an interest rate swap work?
The two parties are typically a CRE borrower and a bank. The borrower agrees to pay the bank a fixed rate, and the bank agrees to pay the borrower a floating rate (SOFR). Paired with a floating-rate loan, the floating payments from the swap offset the floating interest on the loan, leaving the borrower with a net fixed cost. The swap is executed for a notional amount that typically matches the loan balance and is governed by an ISDA Master Agreement.
Net fixed cost = swap fixed rate + loan credit spread
Illustrative example (round numbers):
| Cash flow | Rate |
|---|---|
| Loan balance and swap notional | $20,000,000 |
| Borrower pays the lender on the loan | SOFR + 2.50% |
| Borrower receives from the swap bank | SOFR |
| Borrower pays the swap bank | 3.50% fixed |
| Net fixed cost to the borrower | 6.00% |
| Annualized interest at the net rate | $1,200,000 |
Whatever SOFR does, the floating leg received from the bank cancels the loan’s floating component, and the borrower’s cost stays at 6.00%.
How does a swap differ from an interest rate cap?
Swaps are the institutional-grade approach to hedging floating-rate CRE debt. An interest rate cap only protects against rates exceeding a threshold, so the borrower keeps the benefit when rates fall. A swap locks in a known fixed rate, which provides certainty but eliminates that benefit if rates decline.
Swaps are also separate contracts from the loan itself. The swap counterparty may be different from the lender, and the terms of the two contracts do not always align perfectly, so the borrower has to manage both.
What does it cost to terminate a swap early?
The key practical consideration with swaps is the termination cost. A borrower who needs to exit the swap early, because the property is being sold or refinanced or the loan prepaid, must settle the swap’s mark-to-market value. In a falling rate environment the swap has a negative MtM, meaning the borrower owes the bank a termination payment that can run into the hundreds of thousands or millions of dollars.
This termination cost functions like a prepayment penalty and must be factored into any disposition or refinancing analysis, in the same way defeasance or yield maintenance would be on a fixed-rate loan.
How interest rate swaps show up in LoanBoss
LoanBoss tracks hedges with real-time rates and precise settlement calculations for reconciliation, and treats swap breakage as one of the prepayment types it calculates. Swap terms, mark-to-market values, and termination exposure are tracked across the portfolio in partnership with Pensford’s advisory team.
Frequently Asked Questions
What is a plain vanilla interest rate swap?
The most common structure: the borrower pays a fixed rate to the bank and the bank pays the borrower a floating rate, SOFR, on the same notional amount for the same period. Paired with a floating-rate loan, it produces a synthetic fixed rate.
What is the synthetic fixed rate on a swapped loan?
The swap fixed rate plus the loan’s credit spread. The floating payments received from the swap offset the floating interest on the loan, so only the fixed leg and the spread remain.
Which agreement governs an interest rate swap?
An ISDA Master Agreement. The swap is a separate contract from the loan, and the swap counterparty may be a different institution from the lender.
What happens if I sell the property while the swap is in place?
The swap must be terminated and its mark-to-market value settled. If rates have fallen since the swap was executed, the MtM is negative and the borrower owes a termination payment; that payment should be modeled alongside any loan prepayment cost.
Is a swap better than a cap?
A swap gives certainty: a known fixed rate for the term. A cap gives a ceiling while preserving the benefit if rates fall. Neither is better in every case; the choice depends on whether the borrower values certainty over flexibility.
Related Terms
- Hedge Mark-to-Market
- ISDA
- Defeasance
- Interest Rate Cap
- Floating Rate
- Hedge Requirements in Loan Documents: Replacement Caps, Swap Mark-to-Market and What Lenders Test
- Real-Time Prepayment Calculations: Why Your Prepay Estimate Is Wrong and How to Fix It
- SOFR Swap Rates: How Fixed-Rate CRE Loans Are Priced
Part of the LoanBoss CRE Debt Glossary. For hedging-specific terms, see Pensford’s resources.
Sources
- LoanBoss CRE Debt Glossary