The Federal Reserve raised its benchmark interest rates by 75 basis points on Wednesday, the latest in a series of rate hikes intended to cool the economy and bring down inflation. For all Americans, higher interest rates carry weighty financial implications. Main Street business owners are no exception, as the higher interest rates will flow through to the cost of business loans from lenders including national, regional and community banks, as well as the Small Business Administration’s key 7(a) loan program.
Even more significant may be how the economic slowdown being engineered by the Fed influences consumer demand and the growth outlook for Main Street. With the odds of recession mounting as a result, at least partially, of the recent series of Fed rate hikes, the cost to be paid by Main Street isn’t limited to a bigger monthly debt interest payment and higher cost on new loans. The biggest issue is a business lending market that may quickly dry up as banks pull back on loans to conserve capital and limit risk, and an increasingly smaller percentage of business owners meet stricter credit requirements.
The Federal Reserve is likely not done yet with its rate hikes after the Wednesday decision, with additional increases expected again in September and later in 2022. Here is what small business lending experts say entrepreneurs should be thinking about as they face both higher lending costs and the risk of a slower-growing economy.
1. Borrowing costs will be higher, but still coming off historic lows
Interest rates for business loans, at one point last year, dipped below 4%. That didn’t last, and the average small business loan is on its way to as high as 8%, but it is important to remember that borrowing costs remain very low relative to history. Another 75 basis points from the Fed is not insignificant, and it will flow through the bank lending market.
“When the Fed starts hiking it has a ripple effect across all interest rate indices,” said Chris Hurn, the founder and CEO of Fountainhead, which specializes in small business lending.
But Hurn noted that with the historically low rates, the monthly interest payments made by business owners shouldn’t be impacted as much as the headlines might otherwise suggest. A small business owner taking on debt for a $200,000 piece of equipment, for example, will pay a little extra a month — more or less depending on the loan amortization period — but for most loans the increase in monthly interest should not be a major cash flow issue.
“A few hundred basis points, people can withstand,” Hurn said.
“Most business owners look at that monthly amount and they can support that 75 basis points,” said Rohit Arora, co-founder and CEO of Biz2Credit, which focuses on small business lending. “It’s not that significant on a 10-year loan,” he added.
2. Bank lending requirements are tightening and that process will accelerate
The biggest way that the higher rates may hurt small business is in the overall economic and market effect.
The Fed needs to cool the economy to bring inflation down. In some ways, that should help small businesses manage costs, including labor and inventory.
“Ultimately, business owners understand it’s the greater good,” Arora said. “They can’t keep raising wages for employees and have higher inventory costs, and pass them along to customers. The Fed has to do something … and if it is a little more expensive … I do believe it will be for a relatively short period. … I think they can hold their nose and swallow hard and accept it as a condition of tamping down inflation,” he said.
In fact, Wall Street expects the Fed to begin cutting rates again as soon as March 2023 based on expectations for a much weaker economy. But that economic outlook will be the big driver of borrowing trends.
“Banks get worried, and the number of people eligible for loans goes down,” Hurn said.
He has seen this play out multiple times in his over two decades as a lender, as banks and credit unions get increasingly tighter when it comes to making business loans as uncertainty in the economy increases. Banks effectively “go to the sidelines,” he said.
While recent data shows business loan approval rates basically unchanged month over month, the credit policies at banks, from community banks to regional and national banks, are already tightening as the economy moves closer to a recession.
“That is occurring and it will accelerate,” Hurn said.
Banks and financial institutions are in a much better position now than they were in 2008.
“More will be weathering the storm, but will pull back on financing expansion,” he said.
Business owners should expect to see the debt service coverage ratios — the operating income available to service all debt principal and interest — increase from what has recently been as low as 1.25 to as high as 1.5.
Many business “won’t be able to hit those numbers,” Hurn said. “And that is what always occurs when we are in a cycle like this.”
Arora said more restrictive debt terms, known as covenants, are starting to be put back into deals, and as the economy pulls back, business owners should expect to see more of this from banks over the remainder of the year and into 2023.
3. SBA 7(a) loans will get more attention, variable rates are a factor
The fact that banks will be stricter on loans doesn’t mean the need for growth capital is declining.
Small business lending demand has been down for a good reason, with many business owners already helped by the Paycheck Protection Program and SBA Economic Injury Disaster Loan program. But demand has been increasing just as rates started going up, in a similar fashion to consumers running through their pandemic stimulus savings yet also running into tighter lending conditions.
Loans made through the SBA 7(a) loan program tend to be slightly more expensive than average bank loans, but that difference will be outweighed by the availability of debt as banks slow their lending. Currently, bank loans are in the range of 6% to 8% while the SBA loans run a little higher, in the range of 7% to 9%.
When the banks aren’t lending, the SBA loan program will see more activity, which SBA lenders Fountainhead and Biz2Credit say is already happening.
“We’re already seeing the shift in volume,” Arora said. “Our volume has been going up over the past three to four weeks,” he added.
Most small business loans made through the Small Business Administration 7(a) loan program are variable, meaning the interest rate resets every 90 days in response to movement in the prime rate, and the total interest rate is a combination of the prime rate plus a maximum 2.75% additional SBA rate. Federal Reserve rate hikes send the prime rate higher, and that in turn means the monthly interest payments on existing debt through the 7(a) program will soon be higher. The price of any new loans will be based on the new prime rate as well.
Approximately 90% of SBA 7(a) loans are variable, prime rate plus the SBA spread, and of those loan types, 90% or more adjust on a quarterly basis as the prime rate adjusts.
While much of the expected interest rate increases are already priced into bank loans, the SBA loan lag means as individual business owners come up on a 90-day rolling window for an interest rate reset, they should expect a higher monthly payment. But that’s common in the world of SBA loans and given the lengthy amortization schedules — 10 years for working capital and equipment and as long as 25 years for real estate — the difference won’t be great.
If SBA loans were in the range of 5% to 6% last fall, now business owners are looking at 7.5% to low 8%, and that is for loans that are typically 50 basis points to 75 basis points higher than bank loans.
“The bigger advantages are having longer amortizations, a longer time to pay back the loan, so it doesn’t influence cash flow as much month to month, and less covenants,” Hurn said.
The increased interest in SBA loans should last for a while, but Arora said that another 250 basis points in Fed rate hikes and that overall demand will start to dampen. The latest Wall Street forecasts anticipate two more hikes from the Fed this year after Wednesday, with a potential total hike of 75 basis points more across multiple FOMC meetings — 50 in September and 25 later in the year. That’s 150 basis points including Wednesday’s FOMC decision, and when factoring in the 150 points of tightening made earlier in 2022, a total of 300 basis points in higher lending costs.
In taking the benchmark overnight borrowing rate up to a range of 2.25%-2.5% on Wednesday, the consecutive 75 basis point hikes in June and July represent the most aggressive moves since the Fed began using the overnight funds rate as the principal tool of monetary policy in the early 1990s, and took rates back up to where they last peaked in 2019.
4. Women and minority-owned businesses suffer the most
When banks tighten, minority and women-owned small businesses suffer in a disproportionate manner.
Aside longstanding institutional barriers to accessing capital, some of the reasons come down to a business profile among these owners which leads banks to be tougher on them. According to Arora, women and minority-owned businesses tend to be smaller, have less cash flow and less history of servicing debt, and lower margins, which at a time of greater economic pressure makes margins even more vulnerable. They also tend to be concentrated in more sensitive sectors of the economy, smaller retail operations, for example, rather than health care or IT companies. Banks, therefore, are more likely to lend to more established firms able to meet higher debt service coverage ratios.
“That happens in every recession and they have to borrow more expensive debt to stay afloat,” Arora said.
On the plus side, debt already granted through the PPP and EIDL programs has helped to lower the overall debt needs compared to what they would traditionally be at this point in the economic cycle. And their ability to manage cash flow during the pandemic and make payments means they are coming into the slowdown in a better position to access debt, at least compared to history.
5. Rates should not be the No. 1 determinant of business debt decisions
The mortgage market has been the primary example of how quickly sentiment can shift, even when rates remain low relative to history, with homebuyer demand declining rapidly as mortgage rates have gone up. For business owners, the decision should be different and not based solely on the interest rate.
Business owners need to make a calculated decision on whether to take on debt, and that should be based on analysis of the opportunity to grow. Higher cost debt, and a slight drag on margins, is a price that a business should be willing to pay if top line growth is there for the long-term.
Arora says the most likely determinant right now is what happens with consumer demand and the macroeconomy. The lack of visibility in 2008 led many business owners to pull back on debt. Now, an 8% to 9% interest rate on a loan isn’t as big a factor as whether their sales outlook is improving, their average bill going up or down, and their ability to find workers improving or worsening.
“They shouldn’t mind taking the hit on the bottom line if they can see where it’s going, helping to gain more new clients and pay bills, and stock up on inventory ahead of the holidays,” Arora said.
The recent slowdown in commodities inflation, led by gas prices, should help buoy consumer demand and, in turn, improve cash flow for business owners. But Arora said the next major trend in business loan activity will depend on whether demand stays strong. The majority of small business owners expect a recession to start this year, and will be looking for signs of confirmation.
The Fed said in its statement on Wednesday that while recent indicators of spending and production have softened, the job market remains strong and unemployment low. Fed Chair Jerome Powell said in his press conference that he does not think the economy is in a recession, but that as the central bank continues to tighten, it would at some point “become appropriate to slow the pace of increases while we assess how our cumulative policy adjustments are affecting the economy and inflation.”
“Big demand destruction into the holiday season and then they won’t be borrowing,” Arora said. ”What they [small businesses] cannot live with is very steep demand destruction.”