An interest rate swap is a contract in which a commercial real estate borrower and a bank exchange interest payments on a notional amount, so the borrower pays a fixed rate and receives a floating rate. It converts a floating-rate loan into a synthetic fixed payment. The principal is never exchanged; only the net interest difference changes hands.
How Does an Interest Rate Swap Work?
An interest rate swap works by pairing a floating-rate loan with a separate contract that trades the borrower's floating payment for a fixed one. The borrower pays the bank a fixed swap rate and receives a floating rate equal to the loan's index, usually SOFR. The two floating legs offset, so the borrower's net cost becomes the fixed swap rate plus the loan's credit spread.
Per Chatham Financial, most USD swaps now reference SOFR after the LIBOR transition. Only the net difference between the fixed and floating legs is settled each period, calculated on the notional amount. Per Chatham Financial, the notional is a reference figure used to compute payments; it is never lent or repaid, which is what separates a swap from a loan.
Component | Role in the swap |
Notional amount | The reference balance used to size each payment; never exchanged |
Fixed leg | The swap rate the borrower pays, locked for the swap term |
Floating leg | The index the borrower receives, offsetting the loan's floating rate |
Net settlement | Only the difference between the two legs is paid each period |
Why Interest Rate Swaps Matter
Interest rate swaps matter because they let a borrower fix debt service on a floating-rate loan without refinancing into a fixed-rate loan. Per the 5-year SOFR swap rate of about 3.36% reported by Chatham Financial in mid-2026, a borrower on a SOFR-plus-2.50% loan can lock an all-in cost near 5.86% for five years regardless of where SOFR moves.
The tradeoff is asymmetric and often misunderstood. A swap protects against rising rates but obligates the borrower if rates fall, because the fixed leg does not adjust. The quotable point for an operator: a cap is insurance you can walk away from, but a swap is a two-sided contract that can become a liability, so the exit cost matters as much as the entry rate.
Example
A borrower has a $20,000,000 floating loan at SOFR plus 2.50% and enters a 5-year swap at a 3.36% fixed swap rate. The table compares annual interest under the swap against the floating loan at two SOFR levels, using the July 1, 2026 SOFR of 3.66% and a stressed 5.50%.
Item | Swapped (fixed) | Floating at 3.66% SOFR | Floating at 5.50% SOFR |
Effective rate | 3.36% + 2.50% = 5.86% | 3.66% + 2.50% = 6.16% | 5.50% + 2.50% = 8.00% |
Annual interest on $20,000,000 | $1,172,000 | $1,232,000 | $1,600,000 |
Under the swap the borrower pays 5.86%, or $1,172,000 a year, fixed for five years. If SOFR holds at 3.66%, the unswapped loan costs $1,232,000, so the swap saves $60,000. If SOFR climbs to 5.50%, the unswapped loan costs $1,600,000, so the swap saves $428,000. If SOFR instead fell below 3.36%, the swap would cost the borrower more than staying floating.
Variations and Edge Cases
Swaps are not uniform, and structure changes both the protection and the exit cost. The table below covers the variants a borrower should confirm before executing a swap alongside a loan.
Variant | Treatment |
Amortizing swap | Notional steps down to match the loan balance, avoiding over-hedging |
Forward-starting swap | Fixed rate is locked today but payments begin on a future date |
Basis risk | The swap index and loan index differ, so the two floating legs do not fully offset |
Early termination | Requires a mark-to-market settlement based on where rates have moved |
The most misunderstood feature is the breakage cost. Per PSRS, exiting a swap early requires a mark-to-market settlement, and if rates have moved against the borrower's position the termination payment can exceed several percentage points of the notional. A swap is a liability to the borrower when market replacement rates are below the contract swap rate.
Interest Rate Swap vs Interest Rate Cap
An interest rate swap is often confused with an interest rate cap, and both hedge a floating-rate loan, but they behave differently. A swap fixes the rate in both directions: the borrower pays a set rate and gains nothing if rates fall. A cap sets only a ceiling: the borrower pays a floating rate but never above a strike.
The practical difference is cost structure and downside. Per Chatham Financial, a swap has no upfront premium but creates a two-sided obligation with a breakage cost if terminated early. A cap costs an upfront premium that is the borrower's maximum loss, and it can be abandoned without penalty. A swap wins when the borrower wants certainty and expects to hold; a cap wins when the borrower wants floors on risk while keeping upside if rates fall.
Frequently Asked Questions
What is an interest rate swap in commercial real estate?An interest rate swap in commercial real estate is a contract that trades a borrower's floating loan payment for a fixed one on a notional amount. The borrower pays a fixed swap rate and receives a floating rate, converting a floating-rate loan into a synthetic fixed payment without refinancing.
What is the notional amount in a swap?The notional amount is the reference balance used to calculate each swap payment. Per Chatham Financial, it is never lent or repaid; only the net interest difference between the fixed and floating legs is settled each period, which is what distinguishes a swap from a loan.
What is a swap breakage cost?A swap breakage cost is the mark-to-market payment owed when a swap is terminated early. Per PSRS, if rates have moved against the borrower's position the payment can exceed several percentage points of the notional, because the swap becomes a liability when market replacement rates fall below the contract swap rate.
Is an interest rate swap better than a cap?Neither is universally better. A swap fixes the rate with no upfront premium but creates a two-sided obligation and a breakage cost. A cap costs an upfront premium capped as the maximum loss and can be abandoned. A swap suits borrowers wanting certainty; a cap suits borrowers wanting a ceiling while keeping downside benefit.
Related Terms
Interest Rate Cap
Bridge Loan
Debt Service Coverage Ratio
CMBS Loan
Construction Loan