Interest Rate Swaps Gaining in Popularity

As interest rates continue to rise, so do the popularity of interest rate swaps. This has been particularly true recently as the Federal Reserve has continued to raise interest rates in an effort to ward off inflation.

The Fed left the current rate alone at its last meeting on September 20 because a slowing economy – reflecting a cooling housing market and falling energy prices – were relieving inflation pressures. However, it did indicate that future rate hikes are possible. The Fed has raised interest rates 17 consecutive times over the past two years, the longest string of increases in its history.

An interest rate swap – locking in loan interest payments at the current going rate or even higher – can help take some of the risk out of operating a dealership in these economically volatile times.

This is important because interest rates constitute a significant expense for the dealer, impacting the cost of inventory on hand and the mortgage on the building, and even the ability of customers to afford to purchase their cars. The result will be reduced profit margins for the dealer.

Dealers can manage this volatility by fixing – or “swapping” – the interest rates on their loans.

What is an interest rate swap? It is not a lending vehicle but it does work hand-in-hand with that process.

Typically, a dealer can negotiate a loan with a swap-provider – usually a bank – with a set interest rate for the life of the deal, helping eliminate some of the risk of doing business today.

Dealers may choose to take a middle-of-the-road approach by doing a swap with only a portion of
their loans.

Available since the 1970s, interest rate swaps now are coming into their own as dealers and others become more familiar and comfortable with the concept.

Here's an example of one auto dealer who benefited greatly from a well-timed interest rate swap: In mid-2005, the prime rate (the rate at which commercial banks lend money to their best customers)
was 6.5 percent.

The dealer, concerned about rising rates, locked in a large, five-year loan at a higher rate, 7.5 percent. This meant his current costs rose immediately. However, when rates surged past that level to the current 8.25 percent rate, he more than recouped his initial losses.