Inflation and Rising Rates: What Borrowers Need to Know
As you have read or heard on the news, the Federal Reserve has raised interest rates by 75 basis points so far this year, and are indicating there will be many more incremental increases to follow. Loans are priced using a number of different indexes, with the most common being Wall Street Journal Prime Rate and Treasury Constant Maturity rates (3, 5, or 10 year), plus a fixed spread. Changes made in the Fed Funds rate are immediately reflected in the Prime Rate. Economic policy, inflation and changes in the market affect the Treasury rates.
- If you have a fixed rate loan, these increases will not have an immediate impact on you, however, many term loans with fixed rates have one or more pre-set rate resets throughout the term of the loan. At the date of the reset, whatever the prevailing Index rate is plus your pre-determined margin will be your rate for that period and, most likely, your monthly payments will be re-amortized using this new rate.
- If you have a floating rate loan, which is most common with revolving or construction lines of credit, the change in rate will be immediate, and reflected in the interest accrual.
Rates have been historically low for years, with little to no movement. For example, WSJ Prime was 3.25% from December 2008 to December 2015, and again from March 2020 to March 2022. Even so, it is common practice for banks to underwrite loans as actually priced, as well as 1% to 3% above, to ensure a borrower’s ability to repay the loan in a rising interest rate environment.
This debt repayment amount is measured against historic cash flow. Given the cues from the Fed, underwriting will likely stress the interest rate a bit further, as well as finding a “break even” point at a 1:1 coverage of cash flow to debt service, and forecasting its likelihood.
Adding to the mix, we have record inflation, with increased cost of goods, transportation and labor. The use of historic cash flow may no longer be an appropriate test. Don’t be too surprised if that element of your historic financial performance isn’t also stressed in underwriting. Perhaps the best lesson in all of this is not to be surprised at all.
It is a good exercise for all business owners contemplating a new loan request, along with those who have existing loans, to take a close look at these elements. Identify the true purpose of your lending need, and weigh both the pros and cons. It is critical that you have the peace of mind knowing that you have not overextended or over leveraged your company’s assets, and can navigate the choppy waters ahead. Debt is a very valuable tool in supporting and growing your business, with the right structure and amount, but it can sink the ship if it is not the right fit.