The Federal Reserve’s decision to raise interest rates by three-quarters of a percentage point, or 75 basis points, 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 lending fix they have not experienced since the 1990s.
If the Federal Reserve’s FOMC next moves match the market’s expectation for two more interest rate hikes by the end of the year, small business loans will reach at least 9%, maybe higher, and that will bring business owners to a difficult set of decisions. Businesses are healthy today, especially those in the rebounding services sector, and credit performance remains good throughout the small business community, according to lenders, but the Fed’s more aggressive turn against inflation will lead more business owners to think twice about taking out new debt for expansion.
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Partly, it is psychological: with many business owners never having operated in anything but a low interest rate environment, the sticker shock on debt stands out more even if their business cash flow remains healthy enough to cover the monthly repayment. But there will also be more businesses finding it harder to make cash flow match monthly repayment at a time of high inflation across all of their other business costs, including goods, labor, and transportation.
“Demand for lending hasn’t changed yet, but we’re getting dangerously close to where people will start to second guess,” said Chris Hurn, the founder and CEO of Fountainhead, which specializes in small business lending.
“We’re not there yet,” he said. “But we’re closer.”
Increasing interest cost
As traditional banks and credit unions tighten lending standards and businesses begin to breach debt covenants based on debt service coverage ratios — the amount of cash flow needed to cover debt — more business owners will turn to the SBA loan market in which firms like Hurn’s specialize.
“Every time we get into one of these cycles and the economy is slowing and rates are going up, one of the few places to get business credit is SBA lenders,” he said.
But even in the SBA market, business owners are beginning to pause as a result of the Fed’s rate actions, said Rohit Arora, co-founder and CEO of Biz2Credit, which also focuses on small business lending. “From a credit perspective, people are getting more cognizant about increasing interest cost, and that the Fed will keep interest rates at 4-4.50%,” Arora said.
Fed officials signaled the intention on Wednesday of continuing to hike until the funds level hits a “terminal rate,” or end point of 4.6% in 2023.
“Even a month ago, this was a ’2022 phenomenon’ and now they will have to live with the pain for longer,” Arora said. “It’s a harder decision now because you don’t have the Fed ‘put’ behind you,” he added, referring to an environment in which you could bank on adjustable loan rates not going higher.