Entering into a swap used to be an option for a Borrower to exchange their variable floating interest rate for a fixed rate, but we are seeing Lenders requiring Borrowers to perform the swap or else close with a higher floating rate. The Lender’s rationale for this requirement appears to be that without the swap, the floating rate loan is a riskier proposition than a fixed loan, which naturally leads to a higher rate. A traditional real estate borrower entering into a loan today would be hard pressed to find a reason to prepay a loan closed in this low interest rate environment; however, many of our clients prepay their three to five year bridge loan with non-recourse HUD loans. Our Borrowers should be aware that in addition to any prepayment penalties, there may also be a fee to break a swap contract early.

The swap breakage fee will be equal to the difference between the swap contract rate and the replacement rate (usually the present value at the applicable treasury yield, but could also be the rate for a replacement swap contract) multiplied by the loan amount. If there is no interest shortfall because rates have gone up since the closing, the lender may credit the borrower with the savings. If rates have gone down since the loan inception, then there will be swap breakage fees.

For example, assume a $10,000,000 loan with no prepayment penalty and an interest rate of LIBOR plus 400 basis points swaps today at closing for three years at a fixed rate of 5.50%. On the one year anniversary of the loan, when the loan has an outstanding balance of $9,800,000, the Borrower desires to prepay the loan and terminate the swap contract. On that date, the Lender determines that the fixed swap rate is 6.70%, which is essentially a 1.20% annual savings or 0.1% monthly savings. The Lender would then whip out their HP 12 and compute the credit to the borrower of $235,200 ($9.8MM x .10% x 24 months). If, however, interest rates are miraculously lower next year, a payment to the Lender would be due. If the Lender determines on the 2013 payoff date that the swap rate is 5.20%, then the swap breakage fee would be $58,800 or 30 basis points for two years on $9.8MM.