With the Federal Reserve’s latest interest rate hike raising the cost of borrowing by half a percentage point to its highest level in 15 years, the majority of small business loans will reach double-digit interest rates for the first time since 2007.
The cost of borrowing and monthly interest payments on corporate debt have already risen rapidly following consecutive 75 percentage point rate hikes by the Fed, but the 10% level is a psychological threshold that small business credit experts say will weigh on many entrepreneurs who are yet to come never experienced such an elevated credit market.
Small business lenders are limited to a maximum spread of 3% over the prime rate. With Wednesday’s rate hike taking Prime to 7.5%, the most common SBA loans will now surpass the 10% rate level. It is the highest level for the key interest rate since September 2007.
For seasoned small business lenders, this is not a new experience.
“Prime was 8.25% in May 1998 when I started in the SBA lending industry 24 years ago,” said Chris Hurn, founder and CEO of small business lender Fountainhead.
Loans he made back then were at the very usual Prime +2.75% (then the maximum above Prime any lender could charge on an SBA loan), or 11%. But that was more the norm than a fundamental change of course in a short period of time.
“In less than a year, we’re going to go from the 5-6% range to double it, and that’s going to have a huge psychological effect,” Hurn said.
The monthly interest payments that owners will make aren’t very different from what has already become one of the main costs of Fed rate hikes on Main Street. Servicing debt at a time of input and wage inflation is forcing entrepreneurs to make much tougher decisions and sacrifice margins. But there will be an additional psychological effect on potential new applicants. “I think it’s already started,” Hurn said. “Entrepreneurs will be very cautious about taking on new debt next year,” he added.
“Every 50 basis points costs more and there’s no denying that psychologically it’s a big deal. Many business owners have never seen double digits,” said Rohit Arora, co-founder and CEO of small business lending platform Biz2Credit. “Psychology is just as important as facts and could be a game changer. A few people have been saying to me over the past few weeks, ‘Wow, it’s going into double digits.'”
A monthly NFIB survey of business owners released earlier this week found that the percentage of entrepreneurs who cited financing as their biggest business concern hit the highest level since December 2018 — the last time the Fed hiked rates. Almost a quarter of small business owners said they are paying a higher interest rate on their latest loan, the highest since 2008. A majority (62%) of homeowners told the NFIB they were not interested in applying for a loan.
“The pain is already there and there will be more,” Arora said.
That’s because beyond the psychological threshold of breaking the 10% rate level, the Fed is expected to keep rates high for an extended period of time. Even with rate hikes slowing and potential rate hikes halting as early as next year, there is no indication that the Fed will cut rates even if the economy enters a recession. The latest CNBC Fed survey shows that the market is forecasting a peak Fed rate of around 5% in March 2023 and keeping the rate there for nine months. Respondents said a recession, which 61% of them expect next year, wouldn’t change this “longer higher” view.
The latest Fed forecast for the final interest rate, released on Wednesday, rose to 5.1%.
This problem is compounded by the fact that as the economy slows, business owners facing declining sales will need more credit and are unlikely to receive additional support from the Fed or the federal government.
Taking inflation from 9% to 7% is likely the faster change than taking inflation from 7% to 4% or 3%, Arora said. “It will take a lot of time and cause more pain for everyone,” he said. And if rates don’t fall until late 2023 or 2024, that means “a full year of high payments and low growth, and even if inflation falls, not at a pace to offset other costs,” he added.
As economist and former Treasury Secretary Larry Summers recently noted, the economy could enter its first recession in four decades, which will be characterized by higher interest rates and inflation.
“We have a problem with the long haul,” said Arora. “This recession won’t be as deep as 2008, but we won’t see a V-shaped recovery either. Coming out will be slow. The problem is no longer the rise in interest rates, the main challenge will be to stay at this level for some time.”
Margins have already been hurt by the rising cost of monthly payments, and that means more business owners will be cutting back on investments in business and expansion plans.
“When speaking to small business owners who are looking for financing, things are starting to slow down,” Hurn said.
With changing expectations for top-line and earnings growth, the focus is now more on cutting costs.
“It’s having the impact that the Fed wants, but at the cost of the economy and the cost of these smaller companies that aren’t as well capitalized,” he said. “This is how we need to tame inflation, and if it wasn’t already painful, it will become even more so.”
Margins have been hurt due to the cost of monthly payments — even with a low interest rate, the one-year waiver period on SBA EIDL loan repayments has now expired for the majority of business owners who were eligible for that debt during the pandemic, leading to Adding to the monthly debt costs for businesses — and investing back into businesses is slowing while expansion plans are shelved.
Economic uncertainty will cause more business owners to borrow only for immediate working capital needs. Eventually even core investments will be made – if they haven’t already – from equipment to marketing to hiring. “Everyone expects 2023 to be a painful year,” Arora said.
Even in tough economic times, there’s always a need for outside capital, but it dampens interest in growth-oriented capital, whether it’s a new marketing plan, that new device that makes things more efficient or increases in size, or buying the company down the road. “There will continue to be a need for regular business loans,” Hurn said.
While debt coverage ratios — the cash flow required to meet monthly interest payments — are red flags, business owners’ credit profiles have not generally weakened, but banks will continue to tighten lending standards into next year. The percentage of small business lending approvals at major banks fell in November to the second-lowest overall in 2022 (14.6%), according to the latest Biz2Credit Small Business Lending Index released this week; and also declined in small banks (21.1%).
One factor that has yet to take full hold in the commercial lending market is the slowdown in the economy, but this is not yet reflected in the interim financial statements that bank lenders use to review loan applications. Business conditions were better in the first half of the year and as company financial statements and tax returns reflect the economic deterioration in the second half and many companies are unlikely to see year-on-year growth, lenders will turn down more loans.
This implies that demand for SBA loans will remain strong relative to traditional bank loans. But until the Fed stops raising rates, corporate lending could be 11.5% or 12% based on current expectations for the second quarter of 2023. “When I made my first SBA loan, it was 12% and Prime was 9.75 %, but not everyone has the story that I have,” Hurn said.