For Most American Businesses, New Fed Rate Means Loans Now Start at 10%-Plus Interest

• The Federal Reserve raised its benchmark interest rate by 50 basis points on Wednesday, which sends small business loans to the double-digits percentage range for the first time in decades.
• Small business loans are based on the Prime Rate, which will now be 7.5%, the highest since 2007 and pushing most SBA loans to a 10.5% interest rate.
• Monthly interest payments already are much higher than a year ago, but the 10% level is a psychological barrier and form of sticker shock many business owners have never experienced.

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, the majority of small business loans will hit the double-digit interest level for the first time since 2007.

The cost of taking out loans, and making monthly interest payments on business debt already has been rising swiftly after successive mega 75 percentage point rate hikes from the Fed, but the 10% level is a psychological threshold that small business loan experts say will weigh on many entrepreneurs who have never experienced a loan market this elevated.

Small Business Administration lenders are limited to a 3% maximum spread over the Prime Rate. With Wednesday's rate hike raising Prime to 7.5%, the most common SBA loans will now surpass the 10% interest level. It's the highest level for the Prime Rate since September 2007.

Business loan interest rate doubles in less than year

To veteran small business lenders, it's not a new experience.

"Prime was 8.25% in May 1998 when I started in the SBA lending industry, 24 years ago," said Chris Hurn, founder and CEO of small business lender Fountainhead. 

Loans he made at that time were at the very common Prime+2.75% (then the maximum over Prime that any lender could charge on an SBA loan), or 11%. But that was the norm rather than a sea change in rates in a short period of time.

"In less than a year, we will have gone from the 5-6% range to a doubling and it will have a tremendous psychological effect," Hurn said.

Many business owners have never seen double-digits percentage

The monthly interest payment owners will be making isn't very different from what's already become one of the primary costs of Fed rate hikes on Main Street. Servicing debt at a time of input inflation and labor inflation is forcing business owners to make much tougher decisions and sacrifice margin. But there will be an added psychological effect among potential new applicants. "I think it's started already," Hurn said. "Business owners will be very careful taking out new debt next year," he added.

"Every 50 basis points costs more and there's no denying it, psychologically, it is a big deal. Many business owners have never seen double-digits," said Rohit Arora, co-founder and CEO of small business lending platform Biz2Credit. "Psychology matters as much as facts and it could be a tipping point. A few people over the past few weeks have said to me, 'Wow, it will be double digits.'"

More entrepreneurs cite financing as top problem

A monthly NFIB survey of business owners released earlier this week found that the percentage of entrepreneurs who reported financing as their top business problem reached its highest reading since December 2018 — the last time the Fed was raising rates. Almost a quarter of small business owners said they are paying a higher rate on their most recent loan, and the highest since 2008. A majority (62%) of owners told NFIB they are not interested in applying for a loan.

"The pain is already in, 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 elevated for an extended period of time. Even in slowing rate hikes and potentially stopping rate hikes as soon as early next year, there is no indication the Fed will move to cut rates, even if the economy enters a recession. The latest CNBC Fed Survey shows the market forecasting a peak Fed rate around 5% in March 2023 and the rate being held there for nine months. Survey respondents said a recession, which 61% of them expect next year, would not alter that "higher for longer" view.

The latest Fed projection for the terminal 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, and unlikely to see additional support from the Fed or federal government.

Getting inflation down from 9% to 7% was likely to be the quicker 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, not coming down at a pace to offset other costs," he added.

As economist and former Treasury Secretary Larry Summers recently noted, the economy may be moving into the first recession in the past four decades to feature higher interest rates and inflation.

"We are in for a long haul problem," Arora said. "This recession won't be as deep as 2008 but we also won't see a V-shaped recovery. Coming out will be slow. The problem isn't the rate increase anymore, the biggest challenge will be staying at these levels for quite some time."

Cutting costs and using debt capital conservatively

Margins already have been hit as a result of the rising costs of monthly payments, and that means more business owners will cut back on investments back into the business and expansion plans.

"Talking to small business owners looking for financing, it's starting to slow things down," Hurn said.

There is now more focus on cutting costs amid changing expectations for revenue and profit growth.

"It's having the effect the Fed wants but at the expense of the economy and expenses of these smaller companies that are not as well capitalized," he said. "This is how we have to tame inflation and if it hasn't already been painful, it will be more painful."

Margins have been hit as a result of the costs of monthly payments — even at a low interest rate, the yearlong SBA EIDL loan repayment waiver period has now ended for the majority of business owners eligible for that debt during the pandemic, adding to the monthly business debt costs — and investments back into business are slowing down, while expansion plans are being put on hold.

Some think the Fed will overshoot by the second quarter of 2022, a view Hurn holds, and rate cuts may come sooner than the central bank is signaling, which has been predicted by bond fund manager Jeff Gundlach and economist Jeremy Siegel — action in the bond market on Wednesday did not signal investor conviction that the Fed would reach the new 5.1% peak rate.

Economic uncertainty will result in more business owners borrowing only for immediate working capital needs. Ultimately, even core capital expenditures will get hit — if they have not been already — from equipment to marketing and hiring. "Everyone is expecting 2023 will be a painful year," Arora said.

Even in bad economic times, there is always a need for debt capital, but it will curtail the interest in growth-oriented capital, whether it's a new marketing plan, the new piece of equipment making things more efficient or designed to increase scale, or buying the company down the street. "There will continue to be demand for regular business loans," Hurn said.  

More Main Street loan applications being rejected

While debt coverage ratios — the cash flow level needed to make monthly interest payments — are flashing warning signs, the credit profile of business owners hasn't weakened across the board, but banks will continue to tighten lending standards into next year. Small business loan approval percentages at big banks dropped in November to the second lowest total in 2022 (14.6%), according to the latest Biz2Credit Small Business Lending Index released this week; and also dropped at small banks (21.1%).

One factor yet to fully play out in the commercial lending market is the slowdown already in the economy 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 as full year financial statements and tax returns from businesses reflect second half economic deterioration, and likely no year-over-year growth for many businesses, lenders will be denying more loans.

This implies demand for SBA loans will remain strong relative 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 expectations for Q2 2023. "When I made my first SBA loan it was 12% and Prime was 9.75%, but not everyone has the history I have," Hurn said.