Most of us are aware that interest rates have risen a lot in the past few years. I know you may not be aware of this if you live in a cave or are completely unaware of the world of finance around you. But for those of us who live and breathe in this realm, the changes of interest rates are a daily factor on our minds.
The rate changes are across the board. Ten-year U.S. Treasuries were at a low of 1.4% last July and are now bumping the 3.2% yield. On the shorter end of the spectrum, the Fed Funds Rate, which was at 0.07% in October 2015 is now at 2.18%. Thirty-year fixed mortgages recently hit 4.72%, representing a sharp increase from the 3.42% two Septembers ago.
For the borrower, this means that they will pay higher interest rates for loans, that is unless they are doing business with a financial institution which is still living in 2016. If you are in credit, you should be aware of this as you look at budgets and stress test interest expenses that a company may have on those credits which are not fixed rates.
Some borrowers still live in yesterday’s land of interest rates. I recently was shown a term sheet for a project promising an interest rate of 5% for 5 years. The institution we were working with was seeing what sort of deal they could do since the project was attractive to them. The letter, which was by now over a month old, was dated and made in a different rate environment which was not applicable to the cost of funds today. Term sheets should have short times for the borrower to act and as much as possible be based upon a variable rate that will be determined based upon market conditions closer to the time of closing.
Savers can find better rates at financial institutions and in the bond market with the increase in rates. These higher rates may move money back into these markets and away from stocks or other business investment if they believe the premium is not substantial enough to pay them for their risk.
Financial institutions are often those where rising interest rates can create substantial stress. In most cases, the main driver of credit union and bank income is the net interest margin, that is the difference between the interest earned on loans and the interest paid on deposits. If your shop has a lot of fixed rate loans on the books and lots of short term deposits that will come up for repricing before any interest changes in the loans, you will see your net interest margin shrink.
I recently heard this lament from the leadership at a credit union. This shop had done a great job in booking lots of 4 and 5-year new auto loans at rates between 1.99% - 3.99% with promotions they ran. This brought in a lot of small loans, which have costs associated with managing and processing each loan. The CU has deposits which will reprice at higher rates as demanded now by the market. This will squeeze their net interest margin.
The leadership mentioned how their main source of their new accounts started from small car loans in their community. Many of these accounts have a very small deposit account, in some cases just the bare minimum to become a member, in their new deposit accounts. So, the overall result of the campaign was locking in a lot of low interest, small balance loans that will probably not run off for several years, combined with a lack of new deposits balances from these new members.
Today, is a good time to look at the benefits of sound business lending. This strategy can help deploy larger amounts of capital at higher market rates than your typical new car loan. If the loan is structured well, duration risk can be reduced by tying the rate to an outside index, such as U.S. Treasuries.
Developing strong business relationships can also bring in larger deposit balances into your institution. Plus, you can serve the business owners with their personal accounts and may be able to gain access to converting many of their employees to your institution as well.
In many ways, one of the biggest ways you can make an impact in your community is with sound business lending. These loans help provide the necessary capital for companies to grow, providing new jobs and helping other businesses increase sales.