Here to learn what swap rates are and how they can impact mortgage rates? You’ve come to the right page. In this article, we’ll cover just that, what happens when they rise or fall, why they’re so important, and what brokers can do to help their clients.

 

Understanding swap rates

 

Swap rates are agreements between two parties exchanging one stream of future interest payments for another based on a specified principal amount. Mortgage lenders use them to mitigate the interest rate risk in a fixed–rate mortgage.

One party agrees to receive a fixed-rate payment, while the other receives a variable payment.

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It has also been defined as the rate a mortgage lender must pay in order to mitigate the interest rate risk in a fixed–rate mortgage.

 

Some key elements of a swap rate include:

• Notional principal

The principal amount is the theoretical value upon which the swap is based. It is used to calculate the payments but isn’t actually exchanged between the parties.

• Fixed interest rate

The fixed interest rate, or swap rate, is the rate that one party agrees to pay. True to its name, this rate remains fixed throughout the swap, offering the payer a sense of predictability.

• Floating interest rate

The floating rate is usually tied to a benchmark or short-term rate like the SONIA [Sterling Overnight Index Average]. It can fluctuate over time and is occasionally recalculated, such as every three months.

• Tenor

The tenor describes the time until the swap contract expires, ranging from a couple of years to decades. For example, a five-year swap rate lasts five years. A swap rate may be adjusted depending on the maturity of the swap – longer-term swaps, like a 10-year swap rate, generally have higher rates.

• Payment frequency

Payment frequency is how often payments are made. Examples of this include quarterly and annually.

• Payment dates

These specific dates determine when the interest payments will be exchanged between the parties, typically aligned with the payment frequency.

 

How does a swap rate work?

 

1. Coming to an agreement between parties

A swap rate works by enabling two parties to exchange cash flows based on different types of interest rates. One pays a fixed rate based on a notional principal amount, and the other pays a floating rate based on a reference rate.

2. Comparing amounts owed

If the rate is higher than the floating rate, the fixed-rate payer will receive the net difference.

If the floating rate is higher than the fixed rate, the floating-rate payer will owe the net difference.

3. Determining the swap rate

Market conditions usually determine the swap rate and reflect the cost of swapping fixed payments for floating payments over a certain timeframe. This can be impacted by central bank interest rates, inflation, risk perception, and market supply and demand.

4. Engaging with legal counsel

As a swap is a legal contract, each party should consult with a legal professional to draft and review the agreement, ensuring everything has been taken care of and follows necessary regulations.

5. Reviewing

The swap’s performance and factors like interest rate modifications should be continuously reviewed throughout the span of the agreement; reporting on results can be helpful.

6. Settlement

The agreement ends if a party terminates it early or if the swap reaches maturity. Any last payments are made, settling the final obligations.

 

What is an example of a swap rate?

Considering the key components and steps, here is an example of a swap rate: Party A agrees to pay a fixed swap rate of 3% annually based on the notional principal of £1m. In comparison, Party B agrees to pay a floating rate of LIBOR + 1% every six months for five years.

 

Why are swap rates important?

 

Swap rates are vital as they serve as a benchmark for various financial instruments, helping organisations like banks manage risks regarding interest rates and currency fluctuations. They also offer key details about the cost of borrowing and lending.

Swap rates are based on what the markets think interest rates will be. If they rise, then mortgage lenders will increase their pricing to maintain their profit margin, but if they rise too rapidly, they may have to pause lending or withdraw products until pricing stabilises.

 

Why swap rates are used

 

Here are some of the most common reasons why swap rates are used:

• Allowing businesses to protect themselves from interest rate fluctuations

Swap rates enable businesses to hedge against interest rate fluctuations. One party can pay fixed rates while receiving a floating rate from the other party, therefore stabilising their cash flows and protecting against increasing interest rates.

• Increasing predictability

A fixed swap rate allows a party to make more stable, fixed payments, which can be particularly handy for those wanting to budget.

• Offering better terms

Swap rates can provide better terms and more affordable options than direct financing, although this can depend on the market conditions at the time.

• Enhancing customisability

Swap rates are customisable, which means they can be modified to meet the specific needs of each party involved. Swap terms can be adjusted to suit their current financial strategies, including everything from the notional amount to the payment frequency.

• Providing diversification

Interest rate swaps offer a way for companies to diversify their financial portfolio, standing as an alternative to traditional fixed-income options like loans and bonds. This helps decrease the concentration of risk in just one particular type of financial product.

 

Risks of swap rates include:

 

Credit risk

The main risk when using swap rates is the risk that a party fails to meet its payment obligations. This can cause the other party to suffer from financial losses. That’s why swap agreements now generally require collateral.

Interest rate risk

If a party pays a fixed rate and receives a floating rate, and the interest rate falls significantly, they may have to pay more than what the floating rate would have been, leading to financial losses.

Market risk

Market risks include changes in interest rates and economic conditions. Sudden market shifts can impact the swap’s value and can make it particularly tricky to exit or change a swap position.

 

Read more on fluctuating swap rates

• Mortgage rate war comes to possible ‘halt’ as swap rates creep up
• Mortgage rate war begins as swaps fall
• Trump tariffs have led to short-term swap rate drop but future uncertain

 

What makes swap rates rise and fall?

 

Swap rates are based on market assumptions surrounding what interest rates will be over the term of the swap rate tenor, the calculation of which involves a number of factors. Jeremy Duncombe, director of intermediaries at Accord Mortgages, said: “They’re all based on current assumptions, so factors like inflation, the conflict in Ukraine, prices, fuel, gas prices and the general economy will feed into where those forecasts come from.”

In general, rates can rise when investors expect interest rate hikes, higher inflation, or stronger economic performance. Just after Russia’s invasion of Ukraine, inflation in the UK started to rise, resulting in the Bank of England raising the base rate from its record low of 0.1% in December 2021 to 0.25% to curb the impact of rising costs.

On the other hand, swap rates can fall when the outlook points to rate cuts, slowing growth, or increased market uncertainty. This can prompt a shift towards lower yields and safer assets. In 2024, inflation started to return closer to the central bank’s target of 2%, which allowed the Bank of England to start cutting the base rate, leading to reducing swap rates at the time.

 

What can brokers do about changing swap rates?

 

Here’s how you can approach the fluctuating market of swap rates as a broker, according to expert options.

• Brokers should engage with clients early so that they can make informed decisions around their product choices and keep themselves as up to date as possible

Mark Harris, chief executive at SPF Private Clients,  said: “Advisers should be on the front foot to engage with clients.”

He added that understanding the “client’s needs, wants, motivations and concerns” would help advisers make the “most suitable recommendation”.

“Anyone coming off a fixed rate any time soon is likely to experience a payment increase, although some of the horror stories seen in the media are few and far between. Advisers can run through the various product options and assist with budgetary requirements while outlining the pros and cons.”

• Explain the external factors impacting fixed rates

Duncombe believes brokers should explain to their customers that “external factors affect fixed rates more than the base rate” and have a conversation around how this works.

He added: “There’s an opportunity for brokers to reach out to clients to make sure customers are comfortable with their expenditure and their affordability.

“As lenders, we all stress mortgage payments based on much higher rates, but it is worth checking with clients – even if they are locked in for two or five years – to reassure them and make sure they’re comfortable with what happens at the end of the fixed–rate period.”

He continued that it was a good customer retention strategy for brokers to talk to new and existing clients to “reassure and advise them so that they know you are there for them, whatever their circumstances”.

• Encourage discussions and weigh up the pros and cons

An expert said : “For brokers, it’s very difficult for them to advise clients what to do. But I think that there’ll be more and more customers out there wanting advice on interest rates, and brokers are well placed to explain the different options and the pros and cons.”

He said that this could increase discussions around long-term fixed rates and floating–rate mortgages.

 

Stay updated on swap rates

Hopefully, you now have a better idea about what swap rates are, how they work, and what risks you need to be aware of when advising broker clients.

To stay up-to-date with everything you need to know about the latest market news, check out the rest of our website. We offer a breadth of useful information, such as our guides on what influences mortgage pricing and saving on mortgage interest by making overpayments.