Are You Protected Against Rising Rates?

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Interest rates have been low for several years now and many people new to lending have never seen a rising rate environment. Some may be asking "why is this happening and what can we do?”

There are many factors that may be attributing to the situation but to cover them all in depth would be a lot to take in at once. To quickly summarize, in a fast-paced economy, costs go up as spending increases. To slow inflation, rates are increased. How does a rising rate environment impact lending and our economy?

Save vs Spend

When interest rates rise consumers tend to save their money rather than spend it. Deposits may be increasing at your bank or credit union, which will have an impact your financial institution’s balance sheet.

If consumer spending reduces, will this impact your loan portfolio? Possibly. New loan generation may slow and even become more competitive.

Residential mortgage impact

A low-rate environment creates a boost to the mortgage industry. With low mortgage rates, consumers find themselves able to:

  • Purchase a home (possibly for the first time)
  • Refinance at a much lower rate
  • Relocate or move to a larger home
  • Complete home improvements
  • Purchase a 2nd home (vacation, investment, etc.).

For most, purchasing a home is a person’s largest purchase and investment. When rates are low, spending power increases. Many consumers find themselves able to purchase a new home or can afford a larger one.

The low-rate environment can also have an impact on property values. As rates have remained low for several years, property values have increased. When rates rise, real estate values tend to stabilize and at times drop. So, a rising rate environment can negatively impact property values. Generally, new home construction demand lowers when rates increase. Exactly how much the real estate market will be impacted is yet to be seen.

Rising Rates and Your Loan Portfolio

When rates are low, a variable rate can appear attractive to both a borrower (whether consumer or commercial) and to the banker. With the real absence of a rising rating environment for several years, what happens when rates rise and how does it impact your portfolio?

For borrowers on a variable rate loan, you may be seeing requests to refinance at a fixed rate. Your financial institution and the borrower both benefited from the low-rate environment. Refinancing to a fixed rate, may be beneficial, but should not be done for free. For the lender, refinancing comes at a cost as there is time and expense involved (underwriting, loan documentation, etc.).

Selling SBA loans on the secondary market can have a very positive impact on an institution’s financial statements as the fee income for selling the guaranteed portion on the secondary market can be substantial. When the loan originated, not only did your borrower benefit from the lower rate environment, but your financial institution also benefited from the fee income that was realized. Refinancing a variable rate SBA loan (that has been sold on the secondary market) presents its own level of challenges for both lenders and borrowers.

Protect Your Loan Portfolio

Over the last few years, when you originated a loan (especially a commercial loan), did you perform a sensitivity analysis? Did you stress-test the loan with a 1%, 2% or 4% increase in rates? If you didn’t, you may want to consider it when completing a loan review.

Let’s look at basic credit analysis. When underwriting a loan, do you still consider the Five Cs of Credit?

  • Character
    • Credit history
  • Capacity
    • Cash flow – debt to income ratio
  • Capital
    • Liquidity of the borrower
  • Collateral
    • Assets securing the loan
  • Conditions
    • Economic events (i.e. rising rates)

The fifth C (Conditions) would tell us to consider changes in the economy during credit analysis. Obviously, there are some economic events (such as a global pandemic) that typically are not factored into consideration. But should changes in the rate environment be considered as part of your underwriting? The answer is yes.

Consider incorporating a portfolio monitoring tool To help watch for behavioral changes in your borrowers. This could be financial performance, credit activity and deposit accounts. Changes in deposit activity is typically an early indicator to a problem. With the right credit monitoring software, you won’t have to wait until the loan is 90 days past due to take action since at that point, it may be too late.

What’s Next?

Although rising rates will have an impact on lending, the significance of the impact will not be realized for several months. We have all seen rising costs in our everyday shopping. Rising costs are partially due to a high level of consumer spending. The objective of increasing rates is to slow consumer spending and increase stability to the economy.

As your financial institution navigates the rising rate environment, Baker Hill is an experienced and trusted partner that has been helping financial institutions succeed for over 35 years. Our team has the technology combined with the banking expertise to help your bank or credit union remain competitive and drive profitability.

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