A common feature in many loans today includes an optional interest rate swap. This will occur when a borrower, with an existing loan, wants to “swap” a floating interest rate for a fixed rate, or vice-versa. Interest rate swaps are an essential tool for borrowers, investors and lenders.
Commonly, a business may have a loan payable to a bank with interest floating based upon “The London Inter-Bank Offered Rate”, also known as the LIBOR rate. The floating rate may be stated such as; LIBOR plus 1%.
The business owners may want, alternatively, a fixed interest rate on the loan that could be somewhat higher than the floating rate currently charged, but avoids the risk of future higher floating interest rates. Investors and banks are willing to accept this risk and take over the floating interest rate in exchange for a fixed rate.
The reverse is also common whereby a borrower may want to swap a fixed rate for what is, currently, a lower floating rate and accept the risk that interest rates will not rise dramatically in the near future.
There is a huge worldwide market for these instruments as they are a type of financial derivative.
Loans for mortgages on homes or loans for business financing can include this swap feature. The loan proposal may allow for this within a certain time frame and will include a fee if this option is taken.
The market for these loans includes all types of financial dealings. Bonds issuers, banks and financial institutions, portfolio managers and speculators all participate in these transactions. Borrowers should be aware of the basic concepts of this option, and always ask the lender if this can be included as part of any financing package.