We estimate that the average contractual loan commitment for term credit at community banks has decreased from just under five years in 2022 to just under three years currently. The primary reason for this shift is not a change in borrowers’ business models or banks’ preference for repricing term loans, but rather, borrowers’ decision to seek short-term financing in anticipation of the Federal Reserve embarking on an interest rate cutting cycle. Community banks should carefully consider the prudence of such a strategy from both a risk and revenue perspective. We feel that financing long-term assets with short-term debt may be a poor choice for some borrowers.

The Issue

Financing long-term assets such as real estate and long-life equipment with short-term credit facilities creates problems for both borrower and lender. We identify the following five mistakes or pitfalls in this trend.

Changes in Market Expectations:

Markets can move rapidly and market participants do not always clearly appreciate the impact of forward projections. For example, at the start of 2024 the market expected six interest rate cuts, while at the time of writing this article the market expects only 2.6 cuts through the end of the year.  Borrowers that locked short-term financing in 2022 and 2023 will be faced with higher payments for loans repricing today (term rates have adjusted upwards). The market’s expectation will continue to change as the economy changes and the summary from various FOMC members is that they are in no hurry to lower interest rates. Further, the market has already priced in the 2.6 cuts in 2024 (65 bps) and the borrowing rate should already reflect this in the inverted yield curve.

Credit Risk:

Financing long-term assets with short-term liabilities adds credit risk.  If rates are higher when the loan matures or cash flow is lower, the borrower’s debt service coverage ratio (DSCR) may not meet the bank’s underwriting criteria, or the ratio may be below 1.0X.  Further, on a 25-year amortization schedule, the principal repayment in the first few years is very small, thus potentially requiring additional equity from the borrower.

Market Risk:

The market may be wrong about the future pace of interest rate cuts, but the market is especially poor in predicting extreme events. The Federal Reserve is waiting for the economy to slow to cut interest rates, if the economy does slow, the extent of that deceleration is unknown. A plain run-of-the-mill recession, may result in lower interest rates but also lower cash flow, wider credit spreads, lack of willingness by banks to lend, or additional asset classes being out of favor by banks.  Borrowers that may be trying to outsmart the market may be setting their borrowing costs to increase or their loan advance rates to substantially decrease.

CRE A Special Case:

Borrowers with non-owner occupied commercial real estate (NOCRE) projects are in an especially precarious position. NOCRE is already scrutinized by bank regulators. The main reason is that CRE financing is highly levered with minimal ability to lower operation costs or add different revenue streams. CRE loans are almost always highly leveraged: a loan underwritten to 1.20X DSCR, 76% loan-to-value (LTV), 9.2% debt yield, and CRE cap rate of 7.00% results in a loan leverage ratio of 10.83 (total debt divided by net operating income (NOI)).  To get the leverage ratio below 6X (a key underwriting criteria) a CRE loan would need to show 42% LTV and just over 2.0X DSCR.  Therefore, financing long-term NOCRE assets with short-term debt is a particular concern in today’s environment.

Sales Risk:

Let us assume that the borrower’s strategy of using temporary financing did not backfire – a recession did not occur and market rates are lower as predicted by the forward curve.  How did the borrower fare in that scenario? The borrower paid higher interest rates during the short-term financing period, and will obtain a lower rate (as predicted by the forward curve) on longer-term financing.  The borrower’s blended rate is no better than had the borrower taken the longer-term facility at the initial entry point – this is the math of the forward curve and its current inversion.  However, the bank will now need to compete for that borrower’s business again with possible irrationally priced competitors.  Neither the borrower or lender achieved an optimal outcome.

An Alternative Approach 

Community bankers have aood insight into their client’s business models and personal goals.  Bankers should be able to explain the pitfalls outlined above and provide appropriate advice to their clients.  Community bankers can show their clients the impact of higher and lower interest rates in the future and what would make the borrower qualify as a bankable credit.  The lender’s value is being able to offer products that protect the borrower’s liquidity, minimize credit and refinancing risks, and finance the borrower’s business for expected growth and succession planning.


The short-term financing of long-term assets creates several shortcomings.  This structure is often the result of banks inadvertently creating an array of risks to appease a borrower’s misunderstanding of fundamental financing theory and the borrower’s bet that future loan rates will be lower than today’s rates.




Tags: Published: 04/09/24 by Chris Nichols