# Combining adjustable rate mortgages and interest rate swap

The interest rates for mortgages are at a historic low. In order to be able to profit from low interest rates in the long term, fixed mortgages with long terms (10 years) are very popular. One problem is that an early exit from the mortgage can be very expensive because of the early repayment penalties.

I have heard that it is possible to replicate a fixed mortgage yourself. This can be done by taking out a (adjustable) LIBOR mortgage with a lender and hedging it with an interest rate swap. The advertised advantage is that you can get out of the interest swap at any time without penalty.

Now the question arises to me: How one can find and purchase such products for interest rate swap? Are there risks in this case, e.g. in a low to negative interest rate environment?

Mechanically, yes, combining a floating rate loan with an interest rate swap is equivalent to a fixed-rate loan. There's not an exchange for these instruments, though, so you'd have to talk to your bank or broker to see if they have counterparties that trade these to retail investors (they are typically only traded between banks or investment funds)

Practically, you're probably not going to see a significant advantage to doing this. The floating-rate mortgage is already going to have a credit spread that is theoretically equivalent to the spread on a fixed-rate loan, so you're still paying more than "LIBOR" for the mortgage and, all else being equal, should give you roughly the same interest rate in the end. Otherwise, there would be a significant arbitrage opportunity: You'd borrow a million dollars at a floating rate, enter into a million-dollar rate swap to convert it to a fixed-rate loan, and loan out the money (or invest it) to collect interest at a higher rate.

For example, suppose you got a mortgage for "LIBOR + 3%", and the fair swap rate for a 30-year LIBOR swap is 0.5%. If you took out the mortgage and received the floating end of the swap, your payments would be exactly the same as if you had a 3.5% fixed-rate mortgage.

whether there are risks in this case e.g. in a low to negative interest rate environment.

The risk for fixed-rate loans is that the market interest rate goes lower, so that seems less likely to be a concern in a low/negative rate environment.

The advertised advantage is that you can get out of the interest swap at any time without penalty.

I don't think this is the case and I don't see the claim on the linked site (unless the translation is wrong). You can negate a swap by either selling it, paying off the counterparty, or entering into an offsetting swap, but you can't just "exit" a swap agreement without some fair compensation to the counterparty.

• "The advertised advantage is that you can get out of the interest swap at any time without penalty." The point here would be that any penalty you pay is based on the value of the swap itself at that time, depending on if real interest rates had risen or fallen. Whereas to get out of a mortgage, you may need to pay punitive penalties regardless of what real interest rates had done in the meantime. – Grade 'Eh' Bacon Sep 8 '20 at 20:11
• Thank you for your answer, I'll have to carefully study what you wrote and try to understand it. May take some time for me to follow :) – DavWEB Sep 9 '20 at 8:55
• Also, at first glance, the answer (and the comment) seems to have been written with North America in mind. In this case there are probably fundamental differences to the situation in my country. – DavWEB Sep 9 '20 at 8:59
• @DavWEB If there are differences in Switzerland regarding the retail market for swaps I can amend my answer, but the mechanics I described (float+swap=fixed, arbitrage-free pricing) are fundamental and not different regionally. – D Stanley Sep 9 '20 at 12:36
• I'll carefully read what you wrote, read the linked article again and try to figure out what this is all about :) – DavWEB Sep 9 '20 at 16:15