The Federal Reserve's decision to raise interest rates for the third-consecutive time at the Federal Open Market Committee meeting is a step being taken to cool the economy and bring down inflation, but it is also putting small business owners across the country in a tough spot.
Small business loans are expected to reach at least 9% by the end of the year if the Federal Reserve next moves match the market expectation for two more interest rate hikes. Businesses are healthy today, especially those in the recovering services sector, and credit performance remains good throughout the small business community, but the Fed's more aggressive turn against inflation will cause more business owners to think twice about taking out new debt for expansion.
With many business owners never having operated in a low interest rate environment, the sticker shock on debt stands out more even if their business cash flow remains healthy Businesses will find it harder to make cash flow match monthly repayment at a time of high inflation.
Chris Hurn is the founder and CEO of Fountainhead, a small business lending company.
He said that they weren't there yet. We are close.
More business owners will look to the SBA loan market in which firms like Hurn's specialize as traditional banks and credit unions tighten lending standards.
One of the few places to get business credit when the economy slows and rates go up is the SBA.
Even in the SBA market, business owners are pausing as a result of the Fed's rate actions, according to the co- founder and CEO of Biz2 Credit. The Fed will keep interest rates at 4-4.50% and people are becoming more aware of the increase in interest costs.
Fed officials indicated on Wednesday that they would continue to hike until the funds level reached a terminal rate.
They will have to live with the pain for a long time now that this was a ’2022 phenomenon'. He said that it is more difficult to make a decision now that you don't have the Fed's support.
The acknowledgment that the Fed is not likely to reverse its interest rate hikes in a hurry, as inflation proves stickier than previously forecast, and key areas of the economy, like the labor market, don't cool fast enough is reflected in the stock market. Many economists, traders and business owners thought the Fed would cut rates early in the future.
According to a survey of economists and investment managers by CNBC, the Fed is likely to keep rates there for the rest of the decade. There will be at least two more rate hikes in November and December, for a total of at least 75 basis points more, and including Wednesday's hike. That is a big change for businesses.
The two-year treasury bond yield hit its highest rate since 2007, and the central bank's expectations for when it starts cutting rates again pushed out even further in time. The fed funds rate median target is 3.0% in 2025.
SBA loans are floating rate loans, which means they re-adjust based on changes in the prime rate, and that has not been an issue for business owners during the low interest rate environment, but it is suddenly becoming a prominent concern. The interest rates on SBA loans are between 7 and 8%. SBA loans are expected to go as high as 9%-9.5% after the Fed hikes its rate.
While they have floating interest rate loans, most of the business owners don't realize that their loans could go up. With gas prices going down, things looked a lot better. The realization that oil prices don't solve the problem is new for a lot of business owners who thought the Fed wouldn't be so aggressive.
He said that demand for business loans is still healthy and that small business credit performance is still strong because many firms were underleveraged before Covid and then supported by the multiple government programs. The economy is doing well and the majority of small businesses are in the service economy.
Business owners were waiting for the Fed to cut in early 2023 to make new loans. The interest rate environment is poised to go higher and they have been caught flatfooted.
It was true for most of the year that business owners looked at gas prices first. Wage inflation and rent inflation are out of control.
More people are interested in fixed rate products.
Businesses can lock in rates from a year to three years, which is leading to an increase in demand for fixed rate loans. They can at least lock in a rate before the rates start coming down. In the short term, the expectation is that SBA loans will adjust up and non-SBA loans will be shorter tenures.
SBA loans can be as long as ten years.
The change in interest rate outlook may make a fixed rate loan better than an SBA loan. There is a possibility of a downside. It has been difficult to time the Fed's policy. The change from the summer to the winter is proof of that. If there is a significant recession and the Fed starts cutting rates earlier than expected, the fixed-rate loan will become more expensive and you will have to pay prepayment penalties.
If you take a fixed-rate loan in this environment, you need to be aware of that risk.
A higher monthly repayment amount is one of the tradeoffs in choosing a fixed rate loan. The amount a business can afford to pay back every month depends on the amount of income coming in and a fixed rate loan with a higher monthly repayment amount requires a business to have more income to devote to servicing the loan
After 2008, business owners never experienced a jump in SBA loans and now they see monthly interest payments increasing and are starting to plan for it. Even though demand is still healthy, they are worried about the increased interest cost while they are still battling inflation.
The cost of guaranteeing a loan can be significant when the Waiver ends. The SBA fee on a $500,000 loan would cost the business $15,000.
The costs are being added by it.
The need for working capital isn't changing even though oil prices are coming down. Business owners who have been through downturns before know that it's a good time to get credit. In the most severe downturn, you won't get money at all.
Hurn said no one will say keep your head in the sand and wait until the second quarter of next year to see where rates are. When the economy is slowing and there are higher rates, banks are less likely to lend.
The credit profile on Main Street is not typified by loan covenants being ripped more frequently in the economy.
More debt service coverage ratios will get violated if interest rates go up. The lag between Fed policy decisions and economic impact means that sticker forms of inflation will last for longer even as sectors like housing and construction are declining.
Because of high inflation, a lot of the surplus cash businesses are sitting on is being eroded. Business owners are in a better position if they have access to credit before the economy spirals out of control.
In 2008 the issues in the financial sector were larger. Unemployment is much lower, lender balance sheets are stronger, and corporate balance sheets are stronger as well.
A slowing economy is what Hurn said.
Business loans peaked at as high as 12% when he first started. It doesn't help after an artificially low interest rate era if you tell a business owner that rates used to be higher.
People set their expectations for borrowing costs. It is changing in a radical way.
Businesses will be hesitant to borrow if the rate goes close to 10%.
SBA loan rates are going to go up if the Fed's rate goes up by late this year.
If the Fed's aim is to bring inflation down, then another 150-175 basis points in total from the Fed would leave many businesses in a stable condition. How quickly the interest rate actions bring down inflation is a question that needs to be answered.
The lower inflation in stickier parts of the economy would allow small businesses to manage their cash flow better. There will be pain and consumer spending will be down if those things don't happen as quickly as people are expecting. They have to deal with high interest rates and a recession that hasn't happened in 40 years.
Rates are not usually considered when taking out a loan. It should be the opportunity to make money. If a business is looking at cash flow against monthly costs like payroll being harder to make, it might have to wait. All borrowing may need to be applied to working capital if rates go up too much.
The US economy is based on credit. Hurn said that people will continue to borrow, but whether they can get capital from traditional sources remains to be seen.
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