How to Save Interest on Loans

Interest paid by a company on the basis of its preference can be minimized  by following a procedure called swapping of interest rate involving a bank called swap bank. 

Generally small companies prefer to take fixed interest rate loan while big companies prefer variable interest rate loans. The reason is that small companies play on a safer side as variable rate fluctuates on the basis of MIBOR (Mumbai Inter-Bank Offer Rate) or LIBOR (London Inter-Bank Offer Rate). Interest rates will always be high for a small concern than for a big concern. I will try to explain this complex yet simple concept with an example-

Company                      A                                       B

Lender bank                 Bank - A                         Bank – B

Preference IR               Variable                          Fixed

Loan Rates                    Fixed – 7%,                   Fixed –10%,

                                        Variable – MIBOR      Variable –MIBOR+1%

Company A wants to pay lowest possible variable interest rate while Company B, the lowest possible fixed interest rate.  For this purpose SWAP banks are there. Swap banks advises Company A to take loan at fixed interest rate and Company B at variable interest rate, yes opposite of their respective preferences. Now first take company A, loan is taken at fixed rate of 7%, now here comes the financial magic, swap banks will give Co. A 8% interest in exchange of MIBOR. So company A is giving MIBOR to swap bank while receiving 8% interest rate and transferring 7% to lender bank A thus effective cost of Co. A would be 1% less. Now you would think why swap bank will bear the loss of 1%? Let’s move to bank B. Bank B is advised to borrow at a Variable rate of interest. It will give Fixed interest rate to Swap Bank and not 10% but 8.5% (1.5% profit here) and will receive MIBOR to be transferred to Lender Bank B. (1% loss here). So net profit to Bank B would be 0.5%. Note that swap bank is giving 8% and receiving 8.5% thus profiting 0.5%. So everybody is in profit. Company A, Company B and Swap Bank.

In this company A need not to meet company B, they both are unknown to each other. Swap banks coordinate the swap agreements for both companies.  Other types of swaps are Currency Swaps to hedge risk, Commodity swaps and Credit defaults swaps just to name a few. By following the principle of swapping the interest rate, the companies can benefit a lot while taking larger loan amounts.