Mortgages with interest rate swaps: advantages and risks
What is a swap mortgage and how does it work? Comparis explains when to consider a mortgage with a swap, and what the risks are.
17.05.2022
iStock / Pattanaphong Khuankaew
1. How does a swap mortgage work?
A swap mortgage is basically two products. It combines a fixed-rate mortgage with an interest rate swap. Instead of a fixed-rate mortgage, you can also choose the Saron mortgage (Swiss Average Rate Overnight) as the basis for the swap.
With an interest rate swap, borrower and lender exchange the Saron or fixed interest rate for a certain length of time.
The borrower pays a fixed interest rate and is credited the current Saron rate in return. The swap thus offsets the interest rate risk of the Saron mortgage.
If the Saron is below the agreed interest rate, the borrower pays the difference.
If the Saron is above it, the borrower keeps the difference.
Who can take out a swap mortgage?
Most mortgage lenders offer swap mortgages only to individuals with a multi-million franc mortgage portfolio, or to institutional property investors.
2. Example of a mortgage with an interest rate swap
You take out a Saron mortgage and pay mortgage interest of 1.9%. This consists of the actual Saron interest rate (1%) and the lender's margin (0.9 percentage points).
At the same time, you decide on a swap with a term of 10 years. This swap costs 1.95% per year. In return, the bank grants you the aforementioned Saron interest rate of 1%.
The net cost of the swap is therefore currently 0.95% (as at April 2022).
| Saron mortgage | 1.90% |
|---|---|
| 10-year swap | 0.95% |
| Difference compared with Saron rate | – 1.0% |
| Swap mortgage costs | 1.85% |
(as at April 2022)
In this case, you pay a total interest rate of 1.85 percent on the swap mortgage. It behaves like a 10-year fixed-rate mortgage.
3. What are the advantages of a mortgage with an interest rate swap?
A swap mortgage offers you the following advantages:
Inexpensive mortgages
A swap mortgage generally costs less than a fixed-rate mortgage.
Early termination
Cancelling a fixed-rate mortgage early can be very costly. This is related to the high early repayment penalties. If you cancel your mortgage before the end of its term, you must compensate the bank for the margin it has lost, as well as the risk premium it has paid. If you cancel a swap mortgage, however, you only pay the lender the interest rate hedge.
Long terms
If you wish you can take out a swap mortgage with a very long term of 30 to 40 years. This is particularly attractive for investment properties, because interest costs are locked in for owners. Indirectly, so too is the rent that tenants pay.
Flexibility
With a swap mortgage, you can benefit from low interest rates for a few years when Saron rates offer good value. Later, you can hedge against higher interest rates with a forward swap or a swap option.
4. What are the risks associated with a swap mortgage?
If you choose a mortgage with a swap, you should be aware of the following risks:
Negative Saron
If the Saron rate is negative, you must pay the counterparty the Saron interest rate and will not have any interest credited to you. This can make the swap mortgage much more expensive.
Counterparty
Taking out a swap mortgage entails a counterparty risk. Counterparty risk means that you run the risk that the other party will not be able to meet its payment obligations (e.g. in the event of insolvency). The interest rate hedge is worthless if the lender goes under.
Tax
Not all cantons allow the costs of a swap mortgage to be deducted from tax. Many only allow you to deduct the interests costs for the Saron mortgage. Clarify the situation in advance with the relevant tax authority.
Margins
The bank may increase the Saron margin at the end of the framework agreement for the Saron mortgage. This would increase the costs of the swap mortgage.
5. Summary: is a swap mortgage an alternative to a fixed-rate mortgage?
All in all, the swap mortgage offers the following advantages and risks:
| Advantages | Risks |
|---|---|
| Generally costs less than a fixed-rate mortgage | No interest credits if Saron rate is negative |
| Early termination less expensive than with a fixed-rate mortgage | Insolvency of the lender |
| Interest costs for long terms are hedged | Swap interest not tax deductible everywhere |
| Flexibility in connection with Saron interest rates | Costs may increase upon expiry of framework contract |
Used properly, the swap mortgage offers valuable advantages compared with the classic fixed-rate mortgage. It is important that you are aware of the risks. Independent advisors can help you determine your mortgage strategy.
This article was first published on 27.10.2021