With the Federal Reserve’s latest interest rate hike adding half a percentage point to the cost of debt capital and reaching a 15-year high, the majority of small business loans will reach the double-digit interest level for the first time since 2007.
The cost of obtaining loans, and making monthly interest payments on business debt has already skyrocketed after the Fed’s massive 75-percentage-point consecutive increases, but the 10% level is a psychological threshold that small-business loan experts say it will weigh on. Many entrepreneurs who have never experienced a loan market this high.
Small Business Administration lenders are limited to a maximum of 3% on the prime rate. With Wednesday’s rate hike, Prime raised to 7.5%, the most popular SBA loans will now exceed the 10% interest level. It is the highest level of the main 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 Horn, founder and CEO of small business lender Fountainhead.
The loans he offered at the time were at the more popular Prime rate of +2.75% (then the maximum over Prime any lender could charge on an SBA loan), or 11%. But that was the norm rather than a drastic price change in a short period of time.
“In less than a year, we’ll go from the 5-6% range to the multiplex range and it’s going to have a huge psychological impact,” Hearn said.
Holders of monthly interest payments aren’t much different from what has already become one of the primary costs of the Federal Reserve rate hike on Main Street. Debt servicing at a time of inflation of inputs and inflation forces business owners to take tougher decisions and sacrifice margin. But there will be an additional psychological impact among potential new applicants. “I think it really started,” Horn said. “Business owners will be very wary of taking on new debt next year,” he added.
“Every 50 basis points costs more and there’s no denying that, psychologically speaking, it’s a big deal. Not many business owners have seen double digits,” said Rohit Arora, co-founder and CEO of small business lending platform Biz2Credit. “Psychology is as important as the facts and it can be a turning point. A few people over the past few weeks have said to me, ‘Wow, it’s going to be double digits.'”
A monthly NFIB survey of business owners released earlier this week found that the percentage of entrepreneurs who reported financing as the biggest issue in their business reached its highest reading since December 2018 — the last time the Fed raised rates. Nearly a quarter of small business owners said they were paying a higher rate on their most recent loan, the highest since 2008. A majority (62%) of owners told the NFIB that they were not interested in applying for a loan.
“The pain is already there, and there will be more,” said Arora.
This is because beyond the psychological limit of the 10% interest level being breached, the expectation is that the Fed will keep interest rates high for a prolonged period of time. Even in a slowdown in rate hikes and the prospect of halting rate hikes as early as next year, there is no indication that the Federal Reserve will move to cut rates, even if the economy enters a recession. CNBC’s latest Fed poll shows that the market expects the Fed rate to peak around 5% in March 2023 and the rate held there for nine months. Respondents said a recession, which 61% of them expect next year, won’t change the “up for longer” view.
The Fed’s latest forecast for the final interest rate released on Wednesday rose to 5.1%.
This problem will be exacerbated by the fact that as the economy slows, the need to borrow will increase for business owners facing declining sales, who are unlikely to see additional support from the Federal Reserve or the federal government.
Arora said lowering inflation from 9% to 7% was likely to be a faster change than raising inflation from 7% to 4% or 3%. “It will take a lot of time and more pain for everyone,” he said. He added that if prices don’t come down until late 2023 or 2024, that means “a full year of high payments and low growth, and even if inflation does come down, it won’t go down at a pace that offsets other costs.”
As an economist and former Treasury Secretary Larry Summers recently noticedBecause of the advent of higher interest rates and higher inflation rates, the economy may be on its way to its first recession in the past four decades.
“We are in a long-term problem,” Arora said. “This recession won’t be as deep as 2008 but we also won’t see a V-shaped recovery. The exit will be slow. The problem is not to increase the rate anymore, the biggest challenge will be to stay at these levels for some time.”
Margins have already been hurt by rising monthly payment costs, and that means more business owners will cut back on their investment in business and expansion plans.
“When talking to small business owners looking for financing, it’s starting to slow things down,” Hearn said.
There is now more focus on reducing costs amid changing expectations for revenue and profit growth.
“It has the effect the Fed wants but at the expense of the economy and the expenses of these smaller companies that are not well capitalized,” he said. “This is how we have to deal with inflation and if it’s not already painful, it’s going to be much more painful.”
Margins have been hurt as a result of monthly payment costs – even with the low interest rate, the one-year SBA EIDL loan repayment forgiveness period for the majority of business owners who qualify for this debt during the pandemic has now expired, plus monthly business debt costs – and a return to business investment slowing down, while expansion plans are put on hold.
Economic uncertainty will cause business owners to borrow more just to meet immediate working capital needs. Eventually, even basic capital expenditures will be hit—if they haven’t already—from equipment to marketing and staffing. “Everyone expects 2023 to be a painful year,” Arora said.
Even in bad economic times, debt capital is always needed, but it will lessen interest in growth capital, whether it’s a new marketing plan, a new piece of equipment that makes things more efficient or designed to increase scale, or buying the company down the street. “Ordinary business loans will continue to be in demand,” Hearn said.
While debt coverage ratios — the level of cash flow needed to make monthly interest payments — flashed with warning signs, business owners’ credit status hasn’t weakened across the board, but banks will continue to tighten lending standards in the coming year. Small business loan approval ratios at major banks fell in November to the second lowest total in 2022 (14.6%), according to the latest Biz2Credit Small Business Lending Index released this week; It also decreased in small banks (21.1%).
One factor not yet fully operationalized in the commercial lending market is the slowdown in the economy already but not yet in the interim financial statements that bank lenders use to review loan applications. Business conditions were stronger in the first half of the year, and since full-year financials and corporate tax returns reflect an economic downturn in the second half, and likely no annual growth for many companies, lenders will turn down more loans.
This means that the demand for SBA loans will remain strong compared to traditional bank loans. But by the time the Fed stops raising rates, business loans could be at 11.5% or 12%, based on current projections for the second quarter of 2023.” When I made the first SBA loan, it was 12% and Prime was 9.75% But not everyone said Horn.