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What is a 'Floating Interest Rate'

A floating interest rate is an interest rate that moves up and down with the rest of the
market or along with an index. It can also be referred to as a variable interest
rate because it can vary over the duration of the debt obligation. This contrasts with
a fixed interest rate, in which the interest rate of a debt obligation stays constant for
the duration of the loan's term.

BREAKING DOWN 'Floating Interest Rate'


For example, residential mortgages can be obtained with fixed interest rates, which
are static and cannot change for the duration of the mortgage agreement, or with a
floating or adjustable interest rate, which changes periodically with the market. For
example, if someone takes out a fixed rate mortgage with a 4% interest rate, he pays
that rate for the lifetime of the loan, and his payments are the same throughout the
loan's term. In contrast, if a borrower takes out a mortgage with a variable rate, it
may start with a 4% rate and then adjust, either up or down, thus changing the
monthly payments.

How Floating Interest Rates Adjust


In most cases, adjustable-rate mortgages (ARMs) have rates that adjust
based on a preset margin and a major mortgage index such as Libor, the
cost of funds index (COFI) or the monthly treasure average (MTA). For
example, if someone takes out an ARM with a 2% margin based on Libor,
and Libor is at 3% when the mortgage's rate adjusts, the rate resets at 5%
(the margin plus the index).

Credit Cards With Floating Interest Rates


Mortgages are not the only type of loans that can have floating interest
rates. Most credit cards also have floating interest rates. As with
mortgages, these rates are tied to an index, and in most cases, the index is
the current prime rate, the rate that directly reflects the interest rate set by

the Federal Reserve several times per year. Most credit card agreements
state that the interest rate charged to the borrower is the prime rate plus
a certain spread.

Advantages and Disadvantages of Floating Rates


With mortgages, adjustable-rate mortgages tend to have lower introductory
interest rates than fixed rate mortgages, and that can make them more
appealing to some borrowers, especially to borrowers who plan to sell the
property and repay the loan before the rate adjusts or borrowers who
expect their equity to increase quickly as home values increase. The other
advantage is that floating interest rates may float down, thus lowering the
borrower's monthly payments. The key disadvantage, however, is that the
rate may float upward and increase the borrower's monthly payments.

A fixed interest rate is an interest rate on a liability, such as a loan or


mortgage, that remains the same either for the entire term of the loan or for
part of the term. A fixed interest rate is attractive to borrowers who do not
want their interest rates to rise over the term of their loans, increasing
theirinterest expenses.

BREAKING DOWN 'Fixed Interest Rate'


A fixed interest rate avoids the interest rate risk that comes with a floating
or variable interest rate, in which the interest rate payable on a debt
obligation varies depending on a benchmark interest rate or index.

Homebuyers in particular should be aware of the pros and cons of loans


with fixed rates. While shopping for a mortgage or another loan,
consumers should compare fixed-rate loans to products with variable or
floating interest rates.

Advantages of Fixed Interest Rates


Because the interest rates on fixed-rate loans stay the same, the
borrowers' payments also stay the same. This makes it easier to budget for
the future. To illustrate, imagine someone buys a $375,000 home with 20%
down, and he takes out a $300,000 mortgage with a 4% fixed interest rate
with a 30-year term. Every month for the life of the loan, his payments are
$1,432. The homeowner may face varying monthly bills as his property
taxes change or his homeowners insurance premiums adjust, but his
mortgage payment remains the same.

Disadvantage of Fixed Interest Rates


Loans with adjustable or variable rates usually offer lower introductory
rates than fixed-rate loans, making these loans more appealing than fixedrate loans, especially when interest rates are high. As a result, borrowers
are more likely to opt for fixed interest rates during periods of low interest
rates; the opportunity cost, if interest rates go lower, is still much less than
during periods of high interest rates.

Difference Between Fixed and Variable Interest Rates

While fixed interest rates stay fixed or set, variable interest rates vary or
adjust. For example, if a borrower takes out an adjustable rate mortgage
(ARM), he typically receives an introductory rate for a set period of time,
often for one, three or five years. After that point, the rate adjusts on a
periodic basis, as outlined in the mortgage agreement.
To illustrate, imagine the bank gives the borrower a 3.5% introductory rate
on a $300,000 30-year mortgage with a 5/1 ARM. During the first five years
of the loan his monthly payments are $1,347. However, when the rate
adjusts, it increases or decreases based on the interest rate set by the
Federal Reserve or another benchmark index. If the rate adjusts to 6%, for
example, the borrower's payments increase to $1,799. In contrast, if the
rate falls to 3%, the monthly payments fall to $1,265. Conversely, if the
3.5% rate is fixed, the borrower faces the exact same $1,347 payment
every month for 30 years.

Fixed V/s Floating Interest Rates on


Home Loans: Which is a better option?

Getting a home loan is very easy now a days, however choosing the best option
is always a complex aspect. One should do a proper homework before rushing in

to something. While applying for a home loan, the first thing which will bother the
applicants is whether to go for Fixed Interest rate or Floating Interest rates?
Let us see which option is better.
Fixed Interest Rate on Home Loan
Fixed Interest Rate means repayment of home loans in Fixed Equal Installments
over the entire period of loan. In this case the interest rate doesnt change with
Market fluctuations. During the early part of loan tenure the majority of monthly
payments are used to service the interest and principal is served in the later parts
of loan tenure.
Benefits of Fixed Rate home loan

Interest Rate remains fixed irrespective of Market Conditions.

A fixed rate home loan is excellent for those who are good at
budgeting and want a fixed monthly repayment schedule, which
is easy to budget and doesn't fluctuate.

It brings a sense of Certainty and Security.

Drawbacks of Fixed Rate home loan


The major drawback with fixed rate is that it is usually 1 - 2.5% more than the
floating rate home loan. Secondly, if for any reason the interest rate decreases,
the fixed rate home loan doesn't get the benefit of reduced rates and the
borrower has to repay the same amount every time. Another area of concern is
whether the fixed rate home loan is 'truly fixed' or fixed for just few years. This
has to be ascertained while taking the home loan. A 'fixed' home loan, which can
be changed every few years, will definitely wipe out the very spirit of such a loan.
Experts agree on the fact the fixed rate are a better option if the economic
scenario promises a rise in interest rates in near future.
Floating Interest Rate on Home Loan
Floating rate by the name implies that the rate of interest varies with the market
conditions. Floating interest rate home loans are tied up to a base rate plus a
floating element thereof. So, if the base rate varies the floating interest rate also

varies.
Benefits of Floating Interest rate on Home loan

The biggest benefit with floating rate home loans is that they are
at least 1%-2% cheaper than fixed interest rates. So, if you are
getting a floating interest rate of 11.5% while, the fixed loan is
being offered at 14%, you still save money if the floating interest
rate rises by up to 2.5%.

Even if the floating rate goes over the fixed rate, it will be for
some period of the loan not for the entire tenure. The interest
rates will surely fall over a long period and thus floating interest
rate brings a lot of savings.

Drawbacks of Fixed Rate home loan


The drawback with floating interest rate is the uneven nature of monthly
installments. This makes it difficult to budget with floating interest rate home
loans. As seen in recent times due to the hike in floating home loan interest rates,
the borrowers had to shell out thousands per month extra as their EMI's, throwing
their entire budget out of order.
Let us understand it with an example, suppose you have taken a loan of Rs. 25
Lakh for 20 Years.

Floating Interest Rate is 9.75%.

Fixed Interest rate is 10.5%.

If you go with the floating interest rate then the EMI will come to around Rs.
23,712, whereas the EMI under the Fixed Interest rate option will be Rs. 26,660.
So, monthly you end up saving around Rs. 2948.Though this amount look small,
it will make a big difference in the Long Term. However, you will benefit choosing
a floating rate home loan as long as the interests do not go beyond 11.5%.
Conclusion
When it comes choosing the interest rate, majority of home loan borrowers, in
fact over 90% of them go for a floating interest rate home loan. Finally, it is up to

the borrower to decide on what suits him the best. Before taking a decision, it is
advisable for the borrower to compare home loans from different institutions in
detail including the various parameters set forth. If certainty and security are
prime considerations, a fixed rate home loan will be the best, however it won't
come without the premium on interest rates.
Published Dec 15 2011

Interest Rates
Expand AllClose All

Savings Account
SAVINGS BANK ACCOUNT

RATE OF INTEREST#
SENIOR
NORMAL
CITIZEN

MINIMUM BALANCE*

Domestic#
a. With cheque book facility

4.00%

4.00%

b. No Frills Account / Basic Savings Bank Account

4.00%

4.00%

4.00%

4.00%

Metro, Urban - Rs.10,000


Semi Urban - Rs.5,000
Rural - Rs.2,000
Zero

Non Resident
NRO / NRE

Metro, Urban, Semi Urban - Rs.15


Rural - Rs.5,000

# Interest Rate revised from 3.50% p.a to 4.00% p.a w.e.f. May 3, 2011

Fixed Deposits (with premature withdrawal facility)


OPEN FD

Interest rates on Domestic, NRO & NRE


deposits(Less than 1 crore)
Tenure Period
7 days to 14 days
15 days to 29 days

Rate of Interest (% p.a.) w.e.f September 12, 2016


General
Senior Citizen*
4.00
4.50
4.25
4.75

30 days to 45 days
46 days to 60 days
61 days to 90 days
91 days to 120 days
121 days to 184 days
185 days to 289 days
290 days to less than 1 year
1 year to 389 days
390 days to 5 years
5 years 1 day upto 10 years
5 Years Tax saver FD(Max upto Rs. 1.50 lac)

5.50
6.25
6.25
6.50
6.75
6.75
7.00
7.25
7.25
7.25
7.25

6.00
6.75
6.75
7.00
7.25
7.25
7.50
7.75
7.75
7.75
7.75

Note

As interest rates are subject to change without prior notice, depositor shall ascertain the rates on
the value date of FD.

Interest earned on the Fixed Deposit will be subject to Tax Deducted at Source as per Income Tax
laws.

Minimum tenure for Domestic & NRO term deposits is 7 days and no interest is payable for
deposits prematurely withdrawn within the period of 7 days from the date of deposit.

Minimum tenure for NRE term deposits is 1 year and no interest is payable for deposits
prematurely withdrawn within the period of 1 year from the date of deposit.

These revised interest rates will be applicable for new deposits and renewal of existing term
deposits.

*Senior Citizen rates applicable only for domestic term deposit.

#The maximum aggregate amount that can be invested in the Tax Saver FD (80C FD) under a
single PAN is 150,000 and the same cannot be closed prematurely before expiry of the lock-in
period of 5 years.

ICICI bank staff (including retired staff) will get additional 1% rate of interest on domestic deposit
below 1 Cr.

Interest rates on Domestic, NRO & NRE deposits (


1 crore and above )
Single Deposit
Tenure Period
7 days to 14 days
15 days to 29 days
30 days to 45 days
46 days to 60 days
61 days to 90 days
91 days to 120 days
121 days to 150 days

1 crore to less
than 5 crore
5.75
5.75
5.75
6.00
6.00
6.25
6.25

Rate of Interest (% p.a.) w.e.f September 5, 2016


5 crore to less 25 crore to less 250 crore to less 500
than 25 crore
than 250 crore
than 500 crore
a
5.75
5.75
5.75
5
5.75
5.75
5.75
5
5.75
5.75
5.75
5
6.00
6.00
6.00
6
6.00
6.00
6.00
6
6.25
6.25
6.25
6
6.25
6.25
6.25
6

151 days to 184 days


185 days to 210 days
211 days to 240 days
241 days to 270 days
271 days to 300 days
301 days to 330 days
331 days to 364 days
1 year to 389 days
390 days to less than 15 months
15 months to less than 18 months
18 months to 2 years
2 years 1 day to 3 years
3 years 1 day to 5 years
5 years 1 day to 7 years
7 years 1 day to 10 years

6.25
6.50
6.50
6.75
7.00
7.00
7.00
7.25
7.25
7.25
7.25
7.25
7.25
7.25
7.25

6.25
6.50
6.50
6.75
7.00
7.00
7.00
7.25
7.25
7.25
7.25
7.25
7.25
7.25
7.25

6.25
6.50
6.50
6.75
7.00
7.00
7.00
7.25
7.25
7.25
7.25
7.25
7.25
7.25
7.25

6.25
6.50
6.50
6.75
7.00
7.00
7.00
7.25
7.25
7.25
7.25
7.25
7.25
7.25
7.25

6
6
6
6
7
7
7
7
7
7
7
7
7
7
7

Note:

As interest rates are subject to change without prior notice, depositor shall ascertain the rates on
the value date of FD.

Interest earned on the Fixed Deposit will be subject to Tax Deducted at Source as per Income Tax
laws.

Minimum tenure for Domestic & NRO term deposits is 7 days and no interest is payable for
deposits prematurely withdrawn within the period of 7 days from the date of deposit.

Minimum tenure for NRE term deposits is 1 year and no interest is payable for deposits
prematurely withdrawn within the period of 1 year from the date of deposit.

These revised interest rates will be applicable for new deposits and renewal of existing term
deposits.

For terms & conditions and any other details, please contact your nearest ICICI Bank Branch.

Premature withdrawal of deposit:


On pre-mature withdrawal of the DOMESTIC, NRO & NRE deposits:

Interest will be calculated at the rate applicable for the period the deposit has actually remained
with ICICI Bank.

Penalty will be levied on the rate applicable as per the table below

Penal Rates*
Less than 5.0 crore

Original Tenure of Deposit


1 year & above but less than 5 years
5 years and above

Less than 1 year


1.00%
1.00%

*Subject to revision without further notice.

0.50%
1.00%
1.50%

5.0 crore & above


0.50%

Fixed Deposits (without premature withdrawal facility)

Interest rates on Domestic, NRO & NRE deposits (


1 crore and above )
Single Deposit
Tenure Period
7 days to 14 days
15 days to 29 days
30 days to 45 days
46 days to 60 days
61 days to 90 days
91 days to 120 days
121 days to 150 days
151 days to 184 days
185 days to 210 days
211 days to 240 days
241 days to 270 days
271 days to 300 days
301 days to 330 days
331 days to 364 days
1 years to 389 days
390 days to less than 15 months
15 months to less than 18 months
18 months to 2 years
2 years 1 day to 3 years
3 years 1 day to 5 years
5 years 1 day to 7 years
7 years 1 day to 10 years

1 crore to less
than 5 crore
5.75
5.75
5.75
6.00
6.00
6.30
6.30
6.30
6.55
6.55
6.80
7.05
7.05
7.05
7.30
7.30
7.30
7.30
7.30
7.30
7.30
7.30

Rate of Interest (% p.a.) w.e.f September 5, 2016


5 crore to less 25 crore to less 250 crore to less 500
than 25 crore
than 250 crore
than 500 crore
a
5.75
5.75
5.75
5
5.75
5.75
5.75
5
5.75
5.75
5.75
5
6.00
6.00
6.00
6
6.00
6.00
6.00
6
6.30
6.30
6.30
6
6.30
6.30
6.30
6
6.30
6.30
6.30
6
6.55
6.55
6.55
6
6.55
6.55
6.55
6
6.80
6.80
6.80
6
7.05
7.05
7.05
7
7.05
7.05
7.05
7
7.05
7.05
7.05
7
7.30
7.30
7.30
7
7.30
7.30
7.30
7
7.30
7.30
7.30
7
7.30
7.30
7.30
7
7.30
7.30
7.30
7
7.30
7.30
7.30
7
7.30
7.30
7.30
7
7.30
7.30
7.30
7

For availing Fixed Deposit without premature closure facility, please contact your
relationship manager or visit the nearest branch.
Specific Terms and conditions for deposits without premature withdrawal facility

These terms and conditions ("Terms") apply to fixed deposits without premature withdrawal
facility, opened with ICICI Bank, as per the guidelines prescribed by Reserve Bank of India (RBI)
in this regard from time to time ("Fixed Deposit"). These Terms shall be in addition to and not in
derogation of the terms and conditions governing ICICI Bank Fixed Deposits available
on www.icicibank.com ("Primary Terms"). In the event of any contradiction in the Terms and the
Primary Terms, these Terms shall prevail.

The Fixed Deposit does not have premature withdrawal facility i.e. the Fixed Deposit cannot be
closed by the depositor before expiry of the term of such deposit. However, the Bank may allow

premature withdrawal of these deposits in following exceptional circumstances: in the event of


any direction from any statutory and/or regulatory authority or deceased claim settlement cases.

In the event of premature withdrawal of these deposits under above mentioned exceptional
circumstances, the Bank will not pay any interest on the principal amount of the deposit. Any
interest credited or paid upto the date of such premature closure will be recovered from the
deposit amount.

Auto renewal facility is not available for such Fixed Deposits at time of opening of the Fixed
Deposit account. The customer can give renewal instructions within 30 days before maturity date
of such deposit.

Minimum tenure for NRE FD is 1 year and maximum tenure is 10 years.

Minimum tenure for traditional NRO FDs without premature withdrawal facility is 3 months and
maximum tenure is 10 years

Minimum tenure for cumulative NRO FDs without premature withdrawal facility is 6 months and
maximum tenure is 10 years

Interest rates and minimum deposit value are subject to change without prior notice.

Recurring / iWish Deposits


Tenure wise interest rates for Recurring Deposits:
Maturity Period
6 months
9 months
12 months
15 months
18 months
21 months
24 months
27 months
30 months
33 months
36 months
Above 3 years upto 5 years
Above 5 years upto 10 years

Rate of Interest (% p.a.) w.e.f September 12, 2016


General
Senior Citizen
6.75
7.25
6.75
7.25
7.25
7.75
7.25
7.75
7.25
7.75
7.25
7.75
7.25
7.75
7.25
7.75
7.25
7.75
7.25
7.75
7.25
7.75
7.25
7.75
7.25
7.75

Note:

Recurring Deposits will be available for a minimum tenure of 6 months (and in multiples of 3
months thereafter) up to a maximum tenure of 10 years.

As interest rates are subject to change without prior notice, depositor shall ascertain the rates on

the value date of FD

For terms & conditions and any other details, please contact your nearest ICICI Bank Branch.

Penalty on Delayed Installment:

Penalty is charged at monthly interest at the rate of 12 per 1000 for all delayed installments.

Fraction of a month will be treated as full month for the purpose of calculating such interest.

The total interest so chargeable shall be recovered from the total amount of interest payable at
the time of maturity.

Tenure wise interest rates for iWish:


Rates of Interest# (% p.a.) w.e.f September 12, 2016
General
Senior Citizen
6.75
7.25
6.75
7.25
7.00
7.50
7.25
7.75
7.25
7.75
7.25
7.75
7.25
7.75
7.25
7.75

Tenure / Maturity Period


6 months
7 months - 9 months
10 months - 11 months
12 months only
13 months - 24 months
25 months - 3 years
37 months - 5 years
5 years 1 day - 10 years
*Subject to revision without further notice.

Premature withdrawal of Deposit:


On pre-mature withdrawal of the Recurring / iWish deposits:

Interest will be calculated at the rate applicable for the period the deposit has actually remained
with ICICI Bank.

Penalty will be levied on the rate applicable as per the table below

Penal Rates*
Original Tenure of Deposit
1 year & above but less than 5 years
5 years and above

Less than 5.0 crore


Less than 1 year
1.00%
1.00%

0.50%
1.00%
1.50%

Wealth creation is an art, people acquire and master throughout their life. And when
in India, the economy is bending towards middle-class to offer you a taste of wealth
in terms of property, car or bundles of white-goods, finance companies are standing
in queue to back your good old dreams. But rate of interest is a matter of
concern of course and thus what kind of interest rate should you opt for
irrespective of the kind of loan?

5.0 crore & above


0.50%

While fixed rate of interest is determined by the Prime Lending Rate by the finance
companies, floating rate of interest is normally fixed on last auction rate of 91-days
government treasury bill. Prime Lending Rate or PLR is governed by the RBIs
regulation whereas floating rate of interest is the reflection of countrys inflation
scenario. But, for general people like you and me, it is not easy to understand.
Wealth creation demands discipline in due course of time which is available with fixed
rate of interest and thus fixed rate gives you the liberty to plan your future
systematically. As floating interest rate is a kind of unsystematic risk for us, it is
better to avoid this.
Let us discuss the issue with housing finance loan. The southward movement of
interest rate may tempt you to consider all the options to buy a house or purchase a
land. As a result of the periodic fluctuation of interest rate- both upward or
downward, some banks like HDFC started offering the Adjustable Rate Home Loan
(ARHL) facility to enable the well-informed, market savvy customers to take the
benefit of interest rate movements. But, that includes the potential risk of increase in
the interest rate over a period of time.
Let us assume, you are planning to take a loan of Rs 12 lakh with a tenure option of
15-20 years and want to exercise different options to make your final move. Say, the
rate of interest is 12.5 per cent per annum for both fixed rate and floating rate of
interest. Your calculation could be:
Loan
Term

Rate of
Interest
(in per
cent)

Method of
Interest
computation

EMI for
EMI per
Cost of the
Rs.12 Lakh
Rs. I Lakh
Loan *
Loan

15
12.5
Annual Rests
Rs.1,256 Rs.15,072 Rs.27,12,960
Years
20
12.5
Annual Rests
Rs.1,151 Rs.13,812 Rs.33,14,880
Years
* Equated Monthly Installments * 12 Months *Number of Years
Therefore, you can easily understand how to plan your monthly budget to meet your
EMI requirements and you can also calculate the cost of the loan when you will avail
the fixed rate of interest. But, you can not do so, if you are looking for floating rate
of interest.
In case of floating rate of interest, the rate of interest is revised generally in every
six months from the date of first disbursement, if there is a change in PLR. However,
the EMI on the will not change. For instance, if the interest rate increases, the
interest component in EMI will increase; the principal component would reduce,
resulting in an extension of the term of the loan and vice-versa when the interest
rate decreases. You will be provided with an annual statement indicating the details
of the interest and principal payments made during the year. And, ultimately, you
need to plan your budget with an uncertainty in this floating rate of interest that is
not a good move to plan your wealth.
Many people are of opinion thus that, floating rate loans are not suitable in Indian
conditions, since they do not give customers any planning options. Secondly, interest
rates have come down in the recent past, there is a little likelihood that rates will fall
to 3-4 per cent more. And study shows disbursements with floating rate of interest
accounts for only one percent of the total loan disbursement in general. People prefer
fixed rate of interest as they can work out their finances for the period of the loan
more comfortably.
Once one finance company advertised "we can loan you enough money to get you

completely out of debt" but be cautious before you take a final decision. Better to
create the wealth with discipline than to create at the cost of uncertainty.
BANKING CREDIT
Managing interest rate risk with swaps & hedging strategies
PDF
Executive summary
Interest rate swaps and other hedging strategies have long provided a way for
parties to help manage the potential impact on their loan portfolios of changes
occurring in the interest rate environment. A standard interest rate swap is a
contract between two parties to exchange a stream of cash flows according to preset terms. In essence, the transaction involves trading costs associated with two
different types of loanstypically swapping the terms of a floating rate loan for those
of a fixed rate loan or vice versa.
Borrowers may have specific objectives when choosing to participate in an interest
rate swap or related hedging strategy. For example, the goal may be to reduce
interest expense on a particular loan by swapping a higher fixed rate for a lower
floating rate. Alternatively, a borrower may wish to hedge existing interest rate risk
related to the potential that rates will move higher in the future. This is accomplished
by swapping the terms of an existing variable rate loan for those of a fixed rate loan
that will lock in the interest rate on a loan for the loan duration.
An important distinction of an interest rate swap compared to other types of financial
transactions is that principal is never exchanged. The swap represents an agreement
to exchange interest cash flows over time. Interest rate swaps are completely
customizable with flexible terms. The contract is legally separate from the hedged
item, and no upfront premium is required to execute a swap.
This paper provides an overview of the workings of interest rate swaps and related
strategies that individuals or entities may want to consider to help manage interest
rate risk. This includes a discussion of how the interest rate environment may affect
any decisions made about swaps or related hedging strategies.
Fundamental interest rate considerations
Interest rate swaps typically involve trading of a variable rate loan structure for one
with a fixed rate or vice versa. Before considering the viability of pursuing an interest
rate swap, it is important to understand some underlying fundamentals about loans
and how they may influence a swap strategy.
Loans can typically be structured either with a floating rate or a fixed interest rate.
Each comes with its own advantages and disadvantages.

Chart
These are factors that need to be considered not only when first obtaining a loan, but
also when considering whether to swap a loan for one with different terms.
Another consideration is the current state of the interest rate market. While the
future direction of interest rates is not predictable, historical trends can provide some
guidance on potential future trends. This may impact a hedging strategy.
Why consider an interest rate swap?
There are a variety of reasons that an interest rate swap might be considered:
To lock in a fixed interest rate, taking advantage of a favorable environment and
removing interest rate risk as a consideration.
To reduce current interest expense by swapping for a floating rate that is lower than
the fixed rate currently being paid without having to refinance a loan and pay the
associated costs.
To more effectively match interest rate sensitive assets and liabilities.
To better diversify financial risks in a loan portfolio by converting a loan portfolio
from all fixed or all variable to a mix of the two.
To change the interest rate composition of a current loan without facing the expense
associated with refunding or issuing new debt.
Mechanics of an interest rate swap
An interest rate swap represents a derivative product. When two parties agree to an
interest rate swap, they are trading interest rate arrangements. In a typical case, a
borrower that currently carries a loan with a variable interest rate arranges with a
counterparty (such as U.S. Bank) to swap loan terms, exchanging the variable rate
for a fixed rate. The borrower will pay a fixed rate plus any spread that is applied to
the proxy used to determine the variable rate. In return, the counterparty provides
payment of the lending rate (not including any spread), so that portion of interest is,
in essence, canceled out for the borrower.
The exchange includes only interest cash flows over time, with no principal involved.
Each party is simply swapping its existing obligation for the desired obligation. The
fixed rate is based on an average of expected future floating rates.

Here is a simple example of how an interest rate swap arrangement works


A family business borrowed $5 million dollars using a variable rate loan and is now
interested in locking in a fixed rate. Its variable rate loan is priced at 2.17 percent
(the current LIBOR1 rate of 0.17 percent + a 2 percent spread). It comes to an
agreement to pay an additional 1.5 percent to lock in a fixed rate. In effect, the
business agrees to pay interest on its loan at a rate of 3.5 percent (the 2 percent
spread plus 1.5 percent premium for to fix the interest rate). The variable rate loan
minus the spread (currently at 0.17 percent but subject to change) becomes the
responsibility of the counterparty, generally a financial institution. The borrower is no
longer at risk for changes in the variable rate loan. There is no exchange of principal
amounts.
Chart
Other terms that drive the mechanics of the transaction include:
The notional amount of the principal (not the principal itself)
The effective date, termination date and payment dates of the loan
Additional hedging strategies for borrowers
A straightforward swap of one interest rate for another is only one strategy that can
be pursued. Depending on circumstances, other approaches may be more
appropriate. Here are examples of different strategies that can be considered:
Partial Hedge (Blended Rate strategy)
This allows a borrower to use a combination of fixed rate and variable rate loans in
order to manage interest rate risk. For example, consider an individual or entity that
needs to borrow $10 million dollars. The borrower can lock in a fixed rate and limit
the interest rate risk, or use a variable rate as a way to save interest expense
provided that rates don't rise significantly.
Another option is to use a mixed approach, hedging variable rates by locking in a
fixed rate for a portion of the loan. For example, an interest rate swap could be
executed for $6 million of the loan using an interest rate swap while the remaining
$4 million is placed in a variable rate loan. This allows the borrower to experience a
blended rate that is lower than the fixed rate, reducing interest expense for the
period of the loan. If at some point the borrower chooses to swap the variable
portion of the loan, this can be done with less cost than would be the case if the
entire loan were based on a variable rate. Depending on the interest rate
environment, the borrower may realize significant savings by using this blended
strategy.

Blend and extend strategy


An offshoot of the blended rate strategy is to consider refinancing a fixed rate loan
before the term of that loan matures. Terms of commercial loans are often for a
limited number of years. At the time the loan matures, the borrower has to either
refinance or pay off the loan balance. If the interest rate environment is favorable
before the loan matures but the risk of higher rates by the time the term ends is
high, it may be beneficial to refinance the loan prior to maturity of the term. Even if
a swap prepayment penalty is due by refinancing early, the penalty could be blended
into the new rate. This could generate important savings by eliminating the risk of
paying higher interest expenses in the future and the need to pay an upfront fee.
Interest rate cap strategy
Borrowers who are interested in taking advantage of low rates sometimes hesitate to
seek a loan due to the risk that rates will rise down the road. Interest expense may
be the difference in determining whether an investment that must be financed will
ultimately be profitable for the borrower. To help eliminate interest rate uncertainty,
using a variable rate structure, terms can be arranged (for an additional premium)
that allow for the borrower to set a maximum interest rate (ceiling). The applicable
interest rate, which will fluctuate, is capped. Even if rates exceed the ceiling, the
borrower would not pay interest charges higher than the ceiling. This can eliminate
the potential of higher interest expense in the future while still retaining the
possibility for lower interest expense when interest rates remain low.
Forward Rate Lock
Using this strategy, a borrower can arrange a series of loans over a number of years
and lock in a pre-determined interest rate. The rate will be higher than the current
market rate, but it may be an appropriate way to hedge against a significant increase
in rates occurring down the road.
Assessing the interest rate environment
Any swap or hedging strategy needs to take into account the outlook for interest
rates. At the same time, it is important to note that interest rate trends are
inherently unpredictable. Historic trends show that rates can rise or fall quickly in
certain environments. When such dramatic changes occur, borrowers can be caught
by surprise. Hedging positions to prepare for potential changes in interest rates can
be an effective strategy. Borrowers need to consider the current state of the interest
rate environment as they determine a suitable strategy for their loan portfolio.
In recent years, interest rates have hovered near historically low levels. This has
created favorable conditions for borrowers regardless of whether they chose fixed
rate or variable rate loans. The extended period of low rates made variable rate

borrowing particularly attractive. This environment will likely not continue


indefinitely. One lesson from the past is that a dramatic rise in interest rates can
occur over a short period of time. There are numerous examples. Between December
1976 and December 1978, the Fed Funds2 effective rate rose from 4.17 percent to
10.84 percent. The Fed Funds rate stood below 8 percent in June 1980 and by the
end of that year had risen to 20.89 percent. From June to December, 1985, the Fed
Funds rate jumped from 7.95 percent to 13.46 percent. More recently, from June
2004 to September 2006, the rate increased from 0.94 percent to 5.27 percent. All
provide examples that interest rate spikes can happen in short order, and often
without much notice.
Change in Fed funds rate
Chart
Source: Board of Governors of the Federal Reserve System (U.S.)
Shaded areas indicate U.S. recessions - 2015 research.stlouisfed.org
In this current low interest rate environment, borrowers who have been increasingly
dependent on variable rate loans may want to consider swapping for a fixed rate loan
to help manage interest rate risk. This is one way to secure still low interest rates.
In circumstances when interest rates are at higher levels, borrowers may want to
consider swapping their fixed rate loans at higher rates for variable rate loans,
seeking to take advantage of the potential for an improving interest rate
environment. Keep in mind, however, that future interest rate trends are difficult to
predict.
Suitability for interest rate swaps and hedging strategies
Changes in suitability requirements have been implemented for interest rate swaps
as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010,
for example, net worth requirements must be met in order to participate in the type
of transactions discussed in this paper. A financial professional can provide more
details about suitability requirements to participate in interest rate swaps or related
strategies.
Risks associated with derivatives transactions
It is important to be aware of risks that are inherent in any transactions related to
interest rate swaps and related hedging strategies. These include:
Opportunity Costs locking in a fixed rate may result in higher interest expense than
the average of the floating rate over the same period.

Potential Mark-to-Market (Make-Whole) if the swap is unwound prior to maturity


and interest rates have declined, the borrower may be subject to a termination cost.
Liquidity & Credit Pricing Risk the derivative contract is separate and distinct from
the underlying loan. It does not create any commitment to lend or act as a source of
funding. It represents a hedge of changes in a variable rate index only, not a hedge
of the actual credit pricing on the underlying loan. Especially in instances where the
derivative contract maturity extends beyond the loan maturity date, liquidity risk can
result from a failure of the underlying financing to be extended along with the
potential for changes in credit price at any renewal/amendment date.
Basis Risk it is possible that changes in the variable rate index used in the
derivative contract do not perfectly mirror changes in the variable rates used to set
the pricing on the underlying loan.
Settlement a risk exists that the counterparty will fail to make required payments.
Tax & Accounting Issues any person or entity entering into a derivative transaction
is strongly encouraged to consult with tax, legal and accounting advisors to
determine appropriate tax and accounting treatment.
Conclusion
The need to effectively manage interest expense is an important part of any
borrowing plan. The goal may be to limit interest expense or to gain a degree of
certainty about the extent of future interest payments. Managing a loan portfolio can
be challenging given the inherent unpredictability of interest rate trends. Interest
rate swaps and other hedging strategies are tools that borrowers can use to try to
reduce interest expense and/or mitigate interest rate risk.
The Private Client Reserve of U.S. Bank can leverage the capabilities of U.S. Bancorp
Capital Markets' Derivative Products Group. This team of experienced specialists is
focused on providing interest rate management strategies and products to U.S.
Bank's high net worth and broader corporate banking clients. By providing our own
professional capabilities in this specialized area, U.S. Bank offers the potential for
more cost-effective access to swaps and other interest rate strategies that require
the work of a derivatives team.
Another key consideration is the credit quality of the counterparty in any interest rate
derivative transaction. A strong credit profile can offer the potential for reduced
counterparty risk (reduced settlement risk) on derivative transactions.
Our professionals from the Derivative Products Group can work directly with clients
to review an existing loan portfolio. We'll provide an assessment of the interest rate

environment and discuss potential strategies to position the portfolio in a way that is
consistent with your objectives.

Contributed by:
David Crittendon
Managing Director of Banking, Colorado, The Private Client Reserve of U.S. Bank
Polly Ip
Vice President, Derivative Products Group, U.S. Bancorp Capital Markets

1 The London Interbank Offered Rate, a benchmark interest rate that some banks
charge for short-term loans. This is commonly used to calculate rates on a variety of
loans.
2 The interest rate at which a depository institution lends funds on an overnight basis
to another depository institution. It is considered an influential interest rate in the
U.S. economy since it affects monetary and financial conditions.

IMPORTANT DISCLOSURES
Investment products and services are:
Disclosures
The information provided represents the opinion of U.S. Bank and is not intended to
be a forecast of future events or guarantee of future results. It is not intended to
provide specific investment advice and should not be construed as an offering of
securities or recommendation to invest. Not for use as a primary basis of investment
decisions. Not to be construed to meet the needs of any particular investor. Not a
representation or solicitation or an offer to sell/buy any security. Investors should
consult with their investment professional for advice concerning their particular
situation.
EOL

Credit products are offered by U.S. Bank National Association and subject to normal
credit approval. Deposit products are offered by U.S. Bank National Association.
Member FDIC.
U.S. Bank and its representatives do not provide tax or legal advice. Each individual's
tax and financial situation is unique. Individuals should consult their tax and/or legal
advisor for advice and information concerning their particular situation.

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