With the Federal Reserve’s latest rate hike adding half a percentage point to the cost of debt capital and reaching its highest level in 15 years, most small business loans will reach double-digit interest rates for the first time since 2007.
The cost of borrowing and making monthly interest payments on business debt has already risen rapidly following the Fed’s successive 75 percentage point rate hikes, but the 10% level is a psychological threshold that lending experts for small businesses they say it will weigh. Many entrepreneurs who have never experienced such a high loan market.
Small Business Administration lenders are limited to a maximum of 3% distribution over the preferential rate. With Wednesday’s rate hike raising Prime to 7.5%, the most common SBA loans will now exceed the 10% interest level. It is the highest level for the primary rate since September 2007.
For veteran small business lenders, it’s not a new experience.
“Prime was 8.25% in May 1998 when I started in the SBA loan industry, 24 years ago,” said Chris Hurn, founder and CEO of small business lender Fountainhead.
The loans he made at the time were at the very common Prime + 2.75% (then the maximum on Prime any lender could charge on an SBA loan), or 11%. But this was the norm rather than a radical change in rates in a short period of time.
“In less than a year, we’ll have gone from the 5 to 6 percent range to a doubling, and it’s going to have a tremendous psychological effect,” Hurn said.
The monthly interest payment that homeowners will make is not much different than what has already become one of the main costs of Fed rate hikes on the high street. Debt servicing at a time of input inflation and labor inflation is forcing employers to make much more difficult decisions and sacrifice margin. But there will be an added psychological effect among potential new applicants. “I think it’s already started,” Hurn said. “Business owners will be very careful about taking on new debt next year,” he added.
“Every 50 basis points costs more and there’s no denying, psychologically, it’s a big deal. A lot of business owners have never seen double digits,” said Rohit Arora, co-founder and CEO of the small lending platform Biz2Credit companies. “The psychology matters as much as the facts and it could be a tipping point. I’ve had some people say to me in the last few weeks, ‘Wow, it’s going to be double digits.'”
An NFIB monthly survey of business owners released earlier this week found that the percentage of business owners who reported financing as their top business issue reached its highest reading since December 2018 , the last time the Fed raised rates. Nearly a quarter of small business owners said they are paying a higher rate on their most recent loan, the highest since 2008. A majority (62 percent) of owners told NFIB that they are not interested in apply for a loan.
“The pain is already there, and there will be more,” Arora said.
That’s because beyond the psychological threshold of the 10% interest level being breached, the expectation is that the Fed will keep rates high for an extended period of time. Even with rate hikes slowing and the possibility of a rate hike halt as early as next year, there is no indication that the Fed will move to cut rates, even if the economy goes into recession. CNBC’s latest Fed survey shows the market is forecasting a top Fed rate around 5% in March 2023 and the rate staying there for nine months. Survey respondents said a recession, which 61 percent of them expect next year, would not alter that “longer-term” view.
The Fed’s latest projection for the terminal rate released on Wednesday rose to 5.1%.
This problem will be compounded by the fact that as the economy slows, the need to borrow will increase for business owners facing declining sales, and they are unlikely to see additional support from the Fed or the federal government.
Bringing inflation down from 9% to 7% would probably be a faster change than getting inflation from 7% to 4% or 3%, Arora said. “It will take a lot of time and create more pain for everyone,” he said. And if rates don’t come down until late 2023 or 2024, that means “a full year of high payments and low growth, and even if inflation is coming down, it’s not coming down at a pace to offset other costs,” he said. add.
As an economist and ex-Secretary of Finance Larry Summers recently pointed this outthe economy may be entering its first recession in four decades with higher interest rates and higher inflation.
“We are dealing with a long-term problem,” Arora said. “This recession won’t be as deep as 2008, but we won’t see a V-shaped recovery either. The exit will be slow. The problem is no longer rate hikes, the biggest challenge will be staying at these levels for quite some time time”.
Margins have already been hit as a result of rising monthly payment costs, meaning more entrepreneurs will cut back on investment in expansion and business plans.
“Talking to small business owners who are looking for financing, it’s starting to slow things down,” Hurn said.
There is now more focus on cost reduction amid changing expectations for revenue and profit growth.
“It’s having the effect that the Fed wants, but at the expense of the economy and the expenses of these smaller companies that aren’t as well capitalized,” he said. “This is how we have to tame inflation and if it hasn’t been painful already, it’s going to be more painful.”
Margins have been affected as a result of monthly payment costs; even at a low interest rate, the one-year SBA EIDL loan repayment waiver period has ended for most business owners eligible for this debt during the pandemic, adding to monthly business debt costs – and return-to-business investments are slowing, while expansion plans are stalling.
Economic uncertainty will cause more entrepreneurs to guess only for immediate working capital needs. Ultimately, even basic capital expenditures will be affected, if they haven’t already been, from equipment to marketing to procurement. “Everybody expects 2023 to be a painful year,” Arora said.
Even in bad economic times, there is always a need for debt capital, but it will reduce interest in growth-oriented capital, whether it’s a new marketing plan, new equipment that makes things more efficient, or designed to increase the ladder, or buying the company on the street. “It will continue to demand regular business loans,” Hurn said.
Although debt coverage ratios, the level of cash flow needed to make monthly interest payments, are showing warning signs, the credit profile of businesses has not generally weakened, but banks will continue to tighten lending standards next year. Small business loan approval rates at major banks fell in November to the second-lowest total of 2022 (14.6%), according to the latest Biz2Credit Small Business Lending Index released this week; and it also decreased in small banks (21.1%).
One factor that has yet to have a full effect on the commercial lending market is the slowing economy, but not yet on the interim financial statements that bank lenders use to review loan applications. Business conditions were stronger in the first half of the year and, as full-year financial statements and corporate tax returns reflect economic deterioration in the second half and likely no growth year-on-year for many companies, lenders will deny more loans.
This implies that demand for SBA loans will remain strong relative to traditional bank loans. But when the Fed stops raising rates, business loans could be at 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 everybody. has the story that I have,” Hurn said.