Interest Rate Swaps

What is an Interest Rate Swap?

During my 15 years in banking, I found that one of the most confusing products for my clients was an interest rate swap.  It’s not surprising as this is a challenging topic not only for commercial lending clients but for bankers as well. 

What exactly is a swap?  A swap is a derivative contract and/or an agreement between two counterparties to exchange a series of cash flows or financial instruments over a period of time. 

There are Several Different Swap Products

There are several different swap products including Currency Swaps, Commodity Swaps, Interest Rate Swaps, Total Return Swaps, Credit Default Swaps, etc.  

Total Return Swaps have been in the news lately as this was a product used by the Family Office, Archegos Capital Management, run by Bill Hwang.  The collapse of Archegos Capital was brought on by investments in concentrated positions using derivative products such as Total Return Swaps.  Total Return Swaps are common derivative instruments which allow a customer to bet on underlying securities without actual ownership of those securities. 

Investors in these derivative instruments receive the total return of a security from a dealer.  These returns are typically amplified in either direction with the use of leverage. 

The family office, Archegos Capital, was highly leveraged and substantial losses resulted from margin calls and bets turning against the firm.  There was lack of transparency and disclosure between the investment banks and brokers offering the same products; investment banks lost billions.

You may have also heard of a Credit Default Swap (CDS).  A CDS is like an insurance policy that protects against the default of bonds.  Investors also use them to protect against collateralized debt obligations and mortgage-backed securities.  This financial instrument played a big role in the 2008 financial crisis.  According to the International Swaps and Derivatives Association (ISDA), there were $62.2 trillion outstanding Credit Default Swaps by the end of 2007.  Due to the lack of transparency and reporting, it wasn’t realized that the financial institutions selling the credit default swaps were actually undercapitalized.  When debtors defaulted, the system failed and large insurers like AIG were left needing a bailout.  AIG insured collateralized debt obligations (CDOs) against default using credit default swaps.  Although the insurance product generated a lot of revenue for years, big losses took the insurance giant down to its knees when bonds and mortgages defaulted.   

Interest Rate Swaps

Back to our topic at hand, Interest Rate Swaps.  An interest rate swap (IRS) is actually one of the simplest swaps. There are typically two parties that are exchanging interest rates.  The interest rate in an IRS has been based on Libor in the past although banks are required to end the use of Libor at the end of 2021.  The Secured Overnight Financing Rate (SOFR) will likely take its place.

“Plain Vanilla” swaps exchange fixed-rate payments for floating rate payments; this is the most common type of interest rate swap.  One party pays a fixed interest rate while the other party pays a floating interest rate.  Every year the fixed rate payer pays a cash flow that equals a percentage of the principal.  The difference of the cash flow payments is exchanged meaning the principal itself is not exchanged, just the notional principal/cash flows.  The streams of cash flows are called legs of a swap.

After the swap is executed, the bank usually offsets the swap through an inter-dealer broker.  The inter-dealer broker may sell it to counterparties.  Each counterparty may benefit from the exchange.  For example, an interest rate swap product may benefit the lending client by providing a potential reward depending on which direction interest rates are likely to go.  The lending client also benefits by receiving a steady fixed rate which helps to manage cash flow.  Institutional investors use interest rate swaps to manage risk, hedge and speculate on the direction of interest rates. 

Interest rate risk is the main risk within a swap.  Ultimately, it’s a zero-sum game.  The gain of one party will be the loss of the other party.  If your company decides to enter into an IRS contract, it will be bound to the agreement for the length of the contract. 

Advantages of swaps for commercial borrowers:

Borrowers typically want long-term fixed rates.  Since many banks do not want to offer a long-term fixed rate, they may suggest an interest rate swap.  Three main benefits include: possible prepayment benefits; swaps typically provide the lowest rate available; and swaps provides the borrower with a steady fixed rate and flexibility.

How does the bank benefit from Interest Rate Swaps?

Interest rate swaps definitely benefit the bank by reducing interest rate risk.  Banks tend to have a mismatch between their assets and liabilities.  Liabilities are deposits while assets are the loans given to different companies.  Long term loans are funded by short-term deposits. 

If rates were to rise, the bank would be obligated to pay depositors a higher interest rate but are often locked into loans with lower rates.  Banks have a risk management group called Asset Liability Management; this group focuses on the balance sheet by matching the risks of the assets to the risks of the liabilities.  A swap allows the bank to convert some of its long-term fixed rate loans into variable rates.  The bank is safer when they have assets and liabilities at a floating rate. 

There is economic benefit to the bank as well.  The bank receives a fee for executing the original swap.  Non-interest income (fee income) is recognized in the period that the swap is executed. 

What are the Risks of an Interest Rate Swap Product?

There are two main risks: counterparty risk and interest rate risk.  Counterparty risk otherwise known as credit risk relates to the chance that one party will default. Given that many swap contracts are cleared through Center Counter Parties (CCP), default risk is minimized but not eliminated. 

If your bank is suggesting an Interest Rate Swap there are a few things to consider:

  • The borrower must meet swap product eligibility requirements under the Commodity Exchange Act which generally means that a borrower has greater than $10 million in total assets and net worth in excess of $1 million. The borrower must qualify as an Eligible Contract Participant (ECP) and each guarantor must also qualify as an ECP.   Many banks may limit swap transactions for borrowers to those with principal loan amounts of at least $1 million and a minimum of three-year loan term length.
  • Are you comfortable with a variable rate loan or would you prefer a fixed rate loan? Companies with tight cash flow may want a fixed rate loan to minimize vulnerability related to interest rate volatility.  If you are a borrower that is sensitive to changes in interest rates, a fixed rate loan via an IRS may be right for you. 
  • It’s important to consider the future direction of interest rates. In a rising rate environment, the interest rate swap protects the borrower against higher borrowing costs associated with higher interest rates.  If interest rates drop, the borrower will be locked into the swap contract therefore the borrower will forgo the benefit of lower interest rates. 
  • Do you have an interest in paying the loan down early or making extra principal payments? When you enter into an interest rate swap agreement, you are bound to the length of the contract.  Both parties are exchanging a series of cash flows over a specific period of time.  The payment schedule must be followed.
  • If the borrower pays off the loan prior to the date of termination, the borrower will either receive a termination payment from the lender or possibly owe a termination payment to the lender.
  • With a fixed rate loan, a prepayment penalty is due if you pay off the loan early. Variable rate loans do not have prepayment penalties.  With a swap, the borrower must settle the swap contract at market value.  Depending on the direction of interest rates, you may be in a liability or you may have an asset. 
  • A swap will allow you to secure an interest rate on future financing but it should be noted that banks typically require a company to establish an interest rate swap product at the time of loan initiation or before loan initiation (not after the loan is in place).
  • A swap can be completed on just a portion of your loan.

To learn more about LonaRock, LLC and our business debt finance consulting services, please visit our website at or contact us directly at 234-217-9033.  We look forward to helping you become an ideal business client and helping you obtain the best possible financing for your company.

Alternatives to Traditional Financing

If you are looking to raise capital to grow your business, it’s a good idea to explore all options before jumping into a business loan offered by a traditional bank.  This blog will discuss the alternatives to traditional financing but first let’s look at the advantages and disadvantages of traditional bank financing.

Traditional bank financing typically offers lower interest rates than alternative financing options.  Banks offer full relationships with many additional services to cover all of your banking needs.  Traditional banks also allow you to keep full control of your company without giving up a percentage of ownership.  Small businesses may benefit from government backed financing through SBA loans offered at traditional banks. 

The disadvantages include eligibility criteria which is usually stringent.  As the saying goes, “The best time to ask for a bank loan is when you don’t need one!”  Banks offer lower rates because they are typically willing to accept less risk than other capital raising alternatives.  Traditional bank financing also comes with a long application process and a significant amount of documentation.  Please visit our Commercial Banking Documentation Checklist blog for more information about the documentation required. 

There are several alternatives to traditional bank loans.  Each one has their own advantages and disadvantages. 

  • Reputable Online Lenders
  • Crowdfunding
  • Merchant Cash Advances
  • Asset Based Lending
  • Invoice Factoring
  • Equipment Financing
  • Mezzanine Debt
  • Equity Financing
  • Issuing Bonds

Reputable Online Lenders typically offer fast, flexible and secure financing for small businesses.  These online vendors typically base credit decisions on your personal credit score and they require at least one year of business operating history and may require minimum revenue.  Decisions are quick and the funds are typically deposited same day.  They often come with no prepayment penalties and no collateral requirements.  Disadvantages include higher interest rates and the short term nature of the loans.

Crowdfunding offers equity and debt financing solutions.  Crowdfunding is a popular way for start-ups and small businesses to raise capital.   According to a Forbes article, the average crowdfunding campaign is $7,000. Given the small dollar amount, this type of capital may only be sufficient for small businesses and start-ups.  Equity crowdfunding is much like venture capital and angel investing only on a smaller scale.  A business owner gives up a portion of ownership in the business in exchange for capital.  Reward based crowdfunding allows you to offer incentives or rewards for their small donation. 

Merchant Cash Advances are a small business solution for those businesses that need cash quickly.  A merchant cash advance is not technically a loan but you are given a lump sum of money upfront in exchange for your future debit and credit card sales. Like many other cash advance alternatives, MCAs carry high fees and should be used in only the most problematic and dire situations.

Asset Based Lending (ABL) is essentially a business loan secured by the company’s assets.  This business loan typically comes in the form of a revolving line of credit.  If your business has AR, Inventory and Equipment, this might be the best solution for you.  While many traditional banks have ABL departments and specialists, a business can also source an ABL line of credit from private companies that work in specialized finance and factoring.  These private companies may be more costly but credit decisions and funding are typically faster.

Invoice Factoring is an alternative to a bank working capital line of credit.  Invoice Factoring is not a loan therefore collateral is not required.  It allows you to sell your invoices (accounts receivable) to a third party at a discount.  It provides immediate working capital rather than waiting for your customer to pay you.  This is best for B-to-B businesses.  Factoring fees can be expensive as they run from 1% to 5% of the invoice amount.  There may also be hidden fees.  Some of the same non-traditional finance companies that provide ABL lending may also provide factoring services.

Equipment Financing is much like ABL lending in that it is a business loan secured by the company’s assets.  In particular, equipment financing is secured by collateral such as equipment.  While traditional banks offer equipment financing in a streamlined fashion, there are alternatives to traditional banks.  Equipment Finance companies typically have less stringent requirements than traditional banks and funding is fast for both small and large companies. 

Mezzanine Debt is a hybrid between debt and capital.  It is the riskiest form of debt because it is unsecured and subordinated to senior debt.  Mezzanine debt does have priority over common and preferred stock.  This debt often includes warrant options which provide lenders with the right to convert the debt into an equity interest in the company.  Interest on mezzanine debt is tax-deductible. Mezzanine financing is used by PE firms and venture capital companies to help fund buyouts, mergers and acquisitions.  It’s also used by companies looking to fund large projects.  Given that mezzanine debt has the highest form of risk, it also provides opportunities for substantial returns.  Mezzanine debt is best suited for established companies. 

Equity Financing provides a great way to raise capital and fund the growth of your business.  Unlike debt, equity capital does not have to be repaid.  The owner of the business does have to give up a percentage of ownership in the company.  Equity financing can be achieved by taking the company public or via private investors.  Venture Capitalists, Private Equity Firms and Angel Investors are the most common type of equity investors of private companies.  While small businesses may raise capital via equity from friends and family, large established businesses should consider PE, venture capital or even the possibility of an IPO if the business is experiencing rapid growth.  Raising capital via equity can often take a lot of time, energy and requires a lot of out-of-pocket costs.

Issuing Corporate Bonds may provide a flexible way for a company to raise capital.  Corporate bonds are sold to investors; the original investment is returned to the lender/investor when the bond reaches maturity.  The company pays interest payments to the bondholders.  The interest rate is typically higher than debt financing because the bondholders/investors are taking on more risk.  Corporate bonds are a form of debt capital that must be repaid but does not dilute the value of existing shareholders.  Issuing bonds is also much cheaper than issuing equity shares.  There are also tax benefits to issuing bonds as the interest is an expense that reduces taxable income.

This blog was written to inform business owners and executives of the options available to raise business capital.  As you can see, there are several alternatives to traditional financing.  If you have any questions or need further guidance, feel free to reach out to us today. 

To learn more about LonaRock, LLC and our business finance consulting services, please visit our website at or contact us directly at 234-217-9033.  We look forward to helping you become an ideal business client and helping you obtain the best possible financing for your company! 

SBA vs Conventional Business Financing

While conventional business financing typically offers the lowest interest rates, there are times when an SBA loan is the best option or maybe the only option for a small business.  Conventional loans typically require a down payment of at least 20%.  Traditional loans are often the best financing option for established businesses as they are cost effective. 

SBA loans are business loans guaranteed by the Small Business Administration.  The Small Business Administration partners with several banks and lending institutions across the country.  The SBA makes it easier for small businesses and start-ups to get loans through the bank because they help reduce the bank’s risk.  The SBA uses money provided by the government to guarantee up to 85% of the loan amount. 

The two most common types of SBA loans are 7(a) loans and 504 loans.  In this blog, we will explain the two main SBA loan programs as well as the advantages and disadvantages of funding your business via an SBA loan. 

The advantages of SBA loans include lower down payments, extended repayment terms, and competitive interest rates.  SBA loans allow for underwriting based on financial projections which may benefit individuals that are looking to fund a franchise purchase.  SBA lenders allow you to put a minimum of 10% down and loan proceeds can be used for a variety of costs including soft costs, operating cash, franchise fees, etc.  For more information regarding the terms, conditions and benefits of SBA lending, please visit the website.  It is a great resource to find out how an SBA loan can help you fund your growing business. 

The disadvantages of SBA loans include higher costs and a longer application process.  Interest rates are often higher than rates offered in traditional financing.  SBA and closing fees can add up although SBA fees may be rolled into the loan.  The loan application process typically takes longer than a traditional bank loan application.  The SBA will require personal guarantees of the owners with 20% or more ownership in the business.  Although a fully collateralized loan isn’t always required, SBA loans often require that collateral shortfalls be covered by a lien on personal assets.  For loans in excess of $350,000, the lender may take enough collateral to fully secure the loan such as a mortgage on the available equity in your personal real estate.  If your business fails and you are unable to pay back your SBA loan, they have the right to take personal assets such as your home.  The benefits of an SBA loan often outweigh the disadvantages and costs.

The SBA 7(a) loan is the most common loan.  According to the Congressional Research Service, the U.S. Small Business Association backed over $22 billion in SBA 7a loans in 2020.   7(a) loans can be used for working capital, equipment, real estate and other asset purchases.  They are also used for the establishment of a new business.  7(a) loans are great for franchise owners.  The maximum amount for a 7(a) loan is $5 million.  Eligibility requirements include gross annual revenue of at least $100,000 and a credit score of at least 650.  Businesses with tax liens, foreclosures or recent bankruptcies will likely be denied.  A 10% down payment is typically required.  If your real estate purchase represents more than 50% of the debt, then you can finance all of the debt over longer repayment periods. 

SBA 504 loans are a great option for a business that is looking to finance the purchase of fixed assets.  Fixed assets include equipment, buildings and land as well as improvements to an existing building or the funding of construction of a new building.  504 loans cannot be used for working capital, rental real estate or to refinance existing debt.  504 loans are available through Certified Development Companies (CDCs) like Growth Capital in Cleveland Ohio.  The major benefits of 504 loans include lower down payments with a minimum of 10% down, longer amortization periods, no balloon payments, and a fixed rate for the life of the portion of the loan with CDC/SBA.  The CDC in your area works with a bank loan officer to fund your loan using a 50/40/10 split.  The bank covers 50% of the loan, the CDC covers 40%, and the owner covers 10%.

The website has several resources and guides for small businesses.  They cover topics such as planning your business, launching your business, managing your business and growing your business.  They also have a Learning Center on their website that is worth a look.  When a small business doesn’t meet the minimum requirements such as minimum debt service coverage of 1.15x, the SBA team will gladly coach you.

We hope that you have found this information helpful.  We recognize that there are many ways for a business to raise capital.  SBA loans are great for small businesses as they allow for minimal down payments and extended terms.  If you are looking to purchase a franchise, SBA financing may be the best alternative for you. 

Now that you have a better understanding of SBA loans, you are probably wondering how to find an SBA lender.  Some banks are more SBA friendly than others.  The most active SBA Lenders include: Live Oak Banking Company, Huntington National Bank, Newtek Small Business Finance, Celtic Bank, Byline Bank, U.S. Bank and Wells Fargo.  There are also smaller banks throughout the country that are SBA friendly.  Feel free to reach out to us for more guidance. 

To learn more about LonaRock, LLC and our business finance consulting services, please visit our website at or contact us directly at 234-217-9033.  We look forward to helping you become an ideal business client and helping you obtain the best possible financing for your company! 

Becoming an Ideal Business Banking Client

Banks are for-profit businesses.  They get paid to take on a certain amount of risk.  Typically, the interest rate and the terms and conditions offered to you as a client reflect the level of risk your bank incurs by lending to you and your business.  The bank looks to mitigate risk by structuring deals appropriately.  This may include additional covenants, guarantees and/or collateral. 

In order for a bank to make sound lending decisions, bankers and commercial underwriters evaluate the credit risk of each customer and potential customer through a process called Credit Analysis. 

This article should be used as a guideline by business owners and executive management as it relates to the underwriting/approval process. 

By understanding these key credit parameters, you can better prepare for the credit underwriting process.  Have you ever heard of the 5 C’s of credit?  This is an old school way for your lender to assess your risk as a borrower.  The 5 C’s are as follows:

  1. Character – Your credit “character” speaks to the integrity of the owners and management given that these stakeholders are closely tied to the success of the business.  Banks are interested in your work experience and your personal credit history.  The bank may ask for a bio and may require a personal guarantee on the commercial loan.
  2. Capital – Banks will look at the amount of capital assets held by your business.  This includes cash, equipment, inventory, real estate, etc.  The bank also wants to know how much capital has been invested into the business by the shareholders/owners.  Given the amount of risk taken on by a lender, they want to know that you have skin in the game as well.
  3. Collateral – Collateral consists of the capital assets of your business such as commercial real estate, accounts receivable (AR), inventory, cash, equipment, etc. The bank will look at the value of your collateral as well as any existing liens/debt that your business may owe to a lender.

           Although exceptions are made, Banks typically lend using the following advance rates:

    • Up to 80% of Eligible AR (Asset Based Lending and Government Contracts may have a higher advance rate);
    • Up to 60% of Inventory (excluding Work In Process);
    • Blanket Lien on Furniture, Fixtures and Equipment (advance rate of 25%-50%);
    • Up to 80% on Specific Equipment;
    • Commercial Real Estate (typically up to 80%);
    • Land (up to 65%);
    • Marketable Securities and Bonds (Advance rates range from 50% to 90%);
    • Cash has an advance rate of 100% (deposits typically held at the lending bank). 
    • Other collateral may include Cash Value of Life Insurance and Annuities (80% advance rate). SBA loans may allow for different advance rates.

    4.  Conditions – The lender will also consider the conditions of the environment in which you operate; many times, these factors are outside of your control.  External factors may include issues within your industry, competitive advantages/disadvantages, regulatory environment, technology implications, and economic cycles.

    5.  Capacity – Does your business have the financial capacity to support the proposed debt along with your other expenses? The bank will assess your cash flow situation as well as your debt to net worth.  The following Covenants may be added to your loan agreement to address risk:

  • A requirement for Debt Service Coverage typically greater than or equal to 1.20 to 1.00 on a TTM basis. 
  • A requirement for Fixed Charge Coverage typically greater than or equal to 1.10 to 1.00 on a TTM basis. 
  • Maximum Balance Sheet Leverage typically less than or equal to 3.00 to 1.00. 
  • Cash Flow Leverage may also be measured depending on the purpose of the loan. 

When you understand the credit underwriting process and key credit parameters, you can better assess the financial strength of your company and your credit risk profile. 

As you consider your financing options in the marketplace, remember that interest rates and loan structures often vary with the credit and/or investment risk of the company.  The strongest companies often receive the best rates and deal terms and conditions.  It’s important to consider a few different options and be ready to negotiate with your bank as it relates to interest rate, terms, conditions, covenants, etc.

To learn more about LonaRock, LLC and our debt finance consulting services, please visit our website at or contact us directly at 234-217-9033.  We look forward to helping you become an ideal business client and helping you obtain the best possible financing for your company! 

Commercial Loan Documentation Checklist

Business owners and executives obtain capital for various business needs.  The business owner typically has two main options: debt financing and equity financing.  Many companies use a combination of both debt and equity financing.  Debt financing requires repayment whereas equity finance does not require repayment.

The main benefit of debt financing is that the business owner does not have to give up control of the company.  Traditional business debt is also relatively inexpensive and the interest payments are tax deductible.

If you are unsure regarding the best solution for your business, we are here to help you determine the best deal structure given your unique situation.

When you are ready to source a lender for your various capital needs, it is very helpful to have all of the necessary documents ready to be presented to the bank. 

A Loan Documentation Checklist is provided below to be used as a guide.  This will allow the loan application process to go smoothly providing you with a quick turnaround.

When you have familiarized yourself with the documents that are needed to underwrite your business loan request, visit our blog, “Becoming an Ideal Business Banking Client” which speaks to the credit standards that banks typically use to assess the credit risks of each borrower. 

To learn more about LonaRock, LLC and our debt finance consulting services, please visit our website at or contact us directly at 234-217-9033.  We look forward to helping you become an ideal business client and helping you obtain the best possible financing for your company! 

Commercial Loan Documentation Checklist

  • Executive Summary explaining the Purpose of the proposed Transaction
  • Articles of Incorporation and Basic Business Information (Name, EIN, Address, Etc)
  • Recent Business Bank Statement
  • Three Years of Business Financial Statements (Compiled, Reviewed or Audited)
  • Three Years of Business Tax Returns
  • YTD Interim Business Financial Stmt Including Comparable from prior year
  • Business Debt Schedule
  • Financial Projections (if applicable)
  • A/R Aging, A/P Aging and Inventory Report (if applicable)
  • Borrowing Base Report (if currently required on bank loan)
  • Executive Management Bios/Resumes
  • Background information regarding the business, management, competitive landscape etc.
  • Three Years of Individual Tax Returns (including K-1s)
  • Personal Financial Statement (Current)
  • Invoice or Purchase Order for New Equipment (If Applicable)
  • Rent Roll and Schedule of Real Estate (If Applicable)