On March 16, 2022, the Federal Reserve (“the Fed”) raised interest rates by 25 basis points (or “bps”) in an effort to tamp down inflationary pressures. The Fed also indicated that as many as six more increases were likely this year, with more coming in 2023. This announcement provides an opportunity for 7(a) lenders to re-examine their analysis of repayment ability on variable rate loans, the language used in commitment letters, as well as SBA’s rules and regulations pertaining to interest rate increases, the latter of which will be the primary focus of this article.
Interest rate guidance from SBA for 7(a) loans may be found in SOP 50 10 6 on pages 239-246. Other guidance may be found in 13 CFR 120.213, 13 CFR 120.214, and 13 CFR 120.215, as well as in the Servicing and Liquidation Matrix and the 2018 7(a) Loan Authorization Boilerplate. While lenders may be familiar with the basic rules, confusion may occur when rates rise quickly, an environment lenders have not faced for decades. Loan closing staff must be aware of SBA program requirements in order to ensure compliance. Underwriters must also take rising rates into account when considering repayment ability, and commitment letters must anticipate the real possibility that any rate stated shall be subject to upward adjustments.
It appears that the greatest challenge facing lenders today involves the method of setting rates on variable rate loans. When the base rate changes after the date of a lender’s signed commitment letter, what is a lender to do? Is the lender bound by the rate stated? How should lenders select the proper base rate, and ensure that their commitments to their borrowers are consistent with SBA requirements? What base rate must lenders use? The rate in effect at closing? The date of loan approval? Actually neither. For variable rate loans, the base rate is set based on the Prime rate in effect on the first business day of the month in which the loan application is received. Let’s look at an example.
If the application for SBA loan approval was received by SBA in the months prior to April 1, 2022, the initial prime rate will be 3.25%, plus whatever margin is set by the lender (i.e. with a 2.00% margin, the initial note rate would be 5.25%). This would be true if the loan closes in late April, 2022, even though we know that on March 16, 2022, the base rate increased to 3.50%. If the Change Date is every calendar quarter, the prime rate will reset to 3.50% (or whatever the current Prime Rate is) on July 1, 2022. So, the interest rate could remain at 5.50% until October 1, 2022, but only if there are no further rate increases.
While the spread above the base rate as identified in the Note may not be changed during the life of the loan without the written agreement of the borrower, how does a lender treat rate increases when the loan’s repayment terms permit an adjustment “every calendar quarter?” In this case, lenders must look at the rate in effect on the first day of the calendar quarter to determine if another adjustment of interest and/or principal and interest is appropriate. In accordance with the 2018 Loan Authorization Boilerplate, for example, the relevant section may read something like this: “The interest rate will be adjusted every calendar quarter beginning July 1, 2022. The “Prime Rate” is the Prime Rate in effect on the first business day of the month as published in the Wall Street Journal newspaper in which SBA received the application or the first day of the month in which any interest rate change occurs.” In other words, in this example, if there is another rate bump of 25 bps prior to July, 1, 2022, then the adjustment for the next calendar quarter could see the base rate reset at 3.75%, plus the margin of 2.00%, for a new rate of 5.75%.
Considering the unsettled state of the economy caused by rising inflation, supply shortages, and the Russian invasion of Ukraine, interest rates will likely continue to rise. In turn, SBA lenders must be cognizant of the impact that rising rates may have on repayment ability, must modify, if necessary, the language in their commitment letters to anticipate rate hikes, and must draft their loan authorizations with care by staying up-to-date on Fed rate increases. Because charging borrowers a rate higher than authorized may subject lenders to liability from their borrowers, SBA and their primary regulators, it is incumbent for lenders to stay current on future rate adjustments and comply with SBA program requirements.
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