Although rate swaps can cut expense and provide predictability, they also have a potential danger. Dealers can lose money on swaps if interest rates move in the opposite direction from the one they anticipate.
The swaps are a sign not only of increasing rates but also of dealers' growing sophistication. Dealership groups are getting bigger, and several have gone public.
Public dealers are familiar with complex capital markets. They use swaps to stabilize their interest expenses. That improves their ability to make forecasts for investors.
"It is critical that we don't get huge variations in interest expense from year to year," says Sidney DeBoer, chairman of Lithia Motors Inc., a publicly held dealership group in Medford, Ore. "A swap is like buying an insurance policy on interest costs."
Dealers began using swaps in the late 1990s, says Mike Rogers, executive vice president and manager of dealer commercial services of US Bancorp.
Dealers typically use swaps on real estate loans, he says, although some also swap rates on a portion of their floorplan inventory financing. Swap contracts typically last for three, five or seven years.
A swap offers dealers the flexibility to pay off debt early if, for example, a dealership is sold. Commercial loans with fixed rates often include a prepayment penalty. But a dealer can make money on a swap contract if interest rates are higher than they were when the dealer made the swap, Rogers says.
As many as 20 percent of dealers who have commercial loans with Wachovia Corp. are doing interest rate swaps, although few knew about swaps several years ago.
"It's becoming fairly common," says Jerry Bowen, sales director of Wachovia Dealer Financial Services.