Interest rate swap-linked loans caused damage to small businesses in South Korea as such loans raised costs related to derivative contracts amid falling rates, the financial watchdog said Sunday.

Small companies and individual businesses in South Korea continued to lift interest rate swap-linked loans over the past three years, according to the Financial Supervisory Service (FSS).

Growth of the loans, which can transform floating-rate loans to fixed-rate loans via interest rate swap contracts, accelerated from 1.3 trillion won ($1.16 billion) in 2010 to 2.5 trillion won in 2011 and 3.1 trillion won in 2012 respectively.

The loan contact has advantages of interest rate payment around 0.2 percentage point lower than general fixed-rate loans as well as hedging risks of changes in interest rate payment.

The loan, however, raises costs amid lower rate trend because borrowers should liquidate the swap contracts to transform into lower-rate loans. The transformation causes derivative liquidation costs of 1.2 percent and pre-repayment penalties ranging from 1 percent to 1.5 percent.

Bank of Korea (BOK) cut its benchmark interest rate by 25 basis points to 2.5 percent at the May monetary policy meeting, the first alteration in seven months. The unexpected rate cut caused lower market interest rates, leading to lower rates of interest rate swap contracts.