Should We Be Considering Interest Rate Swaps?

By Jonathan D. Moll, CPA

Interest Rate Swaps -Delaware Nonprofit CPA Last Sunday, I decided to take advantage of what could potentially be the last warm and sunny weekend day of the year and cleaned out our garage. Not that I had aspirations of actually creating enough room to fit a car,  but I felt sorry for my 4-year-old son, who had to park his bicycle in the driveway the day before because there was no room left in our garage. The first box that I opened during this task brought me face-to-face with one of my greatest childhood advisors, the Magic 8 Ball.  As I picked up the black sphere of wisdom, I immediately asked it the question that has been keeping me up at nights recently: Is the 30-day LIBOR rate going to increase substantially in the near term?

Nonprofit organizations, like their for-profit small business counterparts, have taken advantage of the record low interest rates and have borrowed money from banks for various reasons such as refinancing mortgages, capital expansion projects, or addressing operational cash flow shortages. In order to maximize the benefits of these low interest rates, the majority of this debt has come in the form of variable rate loans. Despite the short-term benefit of decreased debt service payments due to current interest rate levels, there is a substantial risk on the horizon in that interest rate increases will in-turn increase debt service payments to amounts that nonprofit organizations might not be able to sustain over the long term. Nonprofit organizations should assess their exposure to interest rate risk and evaluate their options to best limit the organization’s exposure to loss from changes in rates.

An interest rate swap is one option that an organization should consider to address this risk.  An interest rate swap is an instrument in which one party exchanges a stream of interest payments for another party’s stream of cash flows. A pay-fixed/receive-variable swap is designed to help manage exposure to increasing variable interest rates.  A nonprofit would receive cash if the variable rate exceeds an agreed-upon fixed rate or pay if the fixed rate exceeds the variable rate. This cash flow stream, combined with the organization’s existing debt service obligation, essentially establishes a net fixed interest rate on the outstanding debt balance or a portion of the outstanding debt balance.  There always exists a short-term cost associated with entering into rate swap agreements as the fixed rate offered is usually higher than the existing variable rate paid during debt service. There’s also a risk that this cost could be prolonged if interest rates remain low for a longer than expected period of time.  Nonprofit financial executives should continuously assess their organization’s exposure to changes in interest rates and be aware of the options, such as interest rate swaps, that are available to mitigate this risk. As always, it would be wise to seek the advice from a professional accounting firm or visit a local toy store to purchase the Magic 8 Ball.

As for the response that I received from the Magic 8 Ball regarding future interest rates: Cannot Predict Now.

Photo by StreetFly JZ (License)

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