In times of rising interest rates, I often get asked how to minimize the risk that interest rates will increase for floating rate loans.
Most banks sell derivative products to protect borrowers from this risk. These products take multiple forms, including rate caps and interest rate “swaps.”
For those who don’t know, interest rate hedge products are financial products designed to enable customers to manage fluctuations in interest rates by means of capping a rate, paying the difference if the rate exceeds a certain rate or is less than a certain rate, or even fixing the interest rate on the loan.
The bank or a third party, usually affiliated with the bank, will enter into a contract that provides that, if the rate exceeds a certain interest rate, the third party will pay the sums due above the rate (an interest rate cap) or the third party will even fix the interest rate where the third party keeps the difference if the swapped (fixed) rate remains above the rate on the loan but pays the difference if the rate on the loan exceeds the swapped rate.
There are also other products available that provide rate certainty for floating rate loans.
In some ways, these products are not much different from the traditional way a bank would fix a rate for a loan. At a closing, the bank prices a loan based upon an index and an interest rate “spread,” then locks your rate at that time. The difference here is that the agreement is with a third party, usually an affiliate of the bank, not the bank itself.
Many lenders previously required that borrowers buy these products to minimize the risk of borrower default under floating rate loans. When rates were low, these products were relatively cheap. This often resulted in a pleasant surprise when borrowers paid off their loans and “unwound” their swaps – it’s a refund to the borrower instead of a prepayment premium. Conversely, if rates drop, and you are not receiving value from the derivative product, there is no financial penalty when you pay off the loan.
Obviously, as interest rates increase these products become more expensive. However, it is always worth asking about the cost, which may vary based upon the product type and the interest rate. It is always an excellent idea to have a sophisticated lawyer review the terms and conditions of these agreements, so you understand the risk.
The product selected will vary based upon the individual’s appetite for risk and the cost of the various products. It may be less costly for a cap than a swap, and the individual borrower may decide that they can tolerate the risk up to the cap. Also, the price will be different based upon the cap or swap selected. For example, a cap at 8% will cost more than a cap at 11% because there is less risk to the party providing the protection.
Usually, the counterparty will require security for their obligation, so that is why it is usually the same bank or its affiliate that issues the derivative product. They will want to place a mortgage against the real property, and the bank making the loan will only permit this mortgage to be in favor of the bank or its affiliate.
These products are typically purchased for a one-time payment, up front, usually at loan closing.
It is important to note that these products are not for everyone and are usually purchased in connection with larger commercial real estate loans.
Howard B. Goldman
PARTNER
38505 Woodward Ave., Suite 100
Bloomfield Hills, MI 48304
(248) 433-2310
hgoldman@plunkettcooney.com
