Variation in Borrowing Costs Between Different States’ Drinking Water and Clean Water State Revolving Fund Programs
By Jake Adams
America needs better water infrastructure - all kinds of infrastructure. Generous tax treatment for investors in local and state government municipal bonds is one way we have supported hundreds of billions in past investments in better water services. This bond market remains the source of funding for 90% of new water projects. However, another program - the state revolving loan funds (SRFs)- has also been an important source of funds.. While the bond market has historically provided most of the capital for water projects, the SRFs almost universally have lower interest rates, especially for municipal entities and utilities with no credit history or a poor one. The differences in interest rates between bonds and SRFs have saved municipalities, utilities, and the communities they serve tens of billions in costs since the Clean Water State Revolving Fund (CWSRF) and Drinking Water State Revolving Fund (DWSRF) programs were established in 1987 and 1997, respectively. Generally, many SRFs with a market-based rate structure offer a base discount from prevailing bond indices - anywhere from 50 to 100 basis points (.5% to 1%). With additional federal dollars available to SRFs through the Infrastructure Investment and Jobs Act (IIJA), SRFs now more than ever serve as a vitally important financing mechanism for rebuilding and restoring our water, wastewater, and stormwater systems.
However, differences in how individual states set interest rates and fees are important, especially because these rates are under the control of state program administrators or legislatures, whereas bond market rates are driven solely by national and global factors. Especially at a time when bond market rates are rising, choices SRF administrators make around interest rates could be profoundly important for municipal entities and utilities seeking to borrow from their SRFs.
The variation of interest rates and fees associated with DWSRF and CWSRF programs affects the total interest cost to borrowers associated with these loans. Understanding the impact of interest rates, and particularly the effects of compounding interest, is crucial for borrowers and policymakers in making informed financial decisions and ensuring sustainable water infrastructure development. As part one in a series of blogs intended to focus on the financial terms and policy implications of state revolving funds, this first piece will analyze the variation of rate structures among the states and look at the potential total borrowing cost of an SRF loan with a few select programs to highlight the differences in how these terms can be structured.
Financing Infrastructure through the SRFs
The DWSRF and CWSRF programs provide low-interest loans and grants to municipal entities, utilities, non-profit organizations, and other entities for constructing, upgrading, or replacing treatment facilities, distribution and conveyance systems, stormwater management, and other related infrastructure. The interest rates on SRF loans can vary based on several factors:
1. Financial Need: Borrowers meeting certain criteria established by the SRF programs that demonstrate financial hardship may qualify for longer-term loans, rate subsidies, waiver of fees, and/or principal forgiveness.
2. Market Conditions: Interest rates can fluctuate with changes in overall economic conditions and the prevailing interest rate environment.
3. Loan Repayment Terms: Longer loan repayment periods may result in slightly higher interest rates to compensate for the extended risk exposure of the lender.
I looked at interest rate information in all 50 states’ DWSRF and CWSRF programs to find patterns in state interest rate and fee policies. In analyzing the program information contained within each state’s Intended Use Plan (IUP), some general observations and categorizations for rate and fee structure were noted.
Total Borrowing Costs: Interest and Fees
Generally, all states have adopted one of two main rate benchmarks: market rate or fixed rate. State SRFs using a market rate approach utilize either their state bond issuance rate for a prescribed fiscal period or one of multiple industry-standard bond market indices as a rate benchmark. Base rates for these states typically align with the established benchmark, with discounts offered based upon specified sub-criteria. Those that use fixed rates generally establish a base rate with no specified or available relationship with a bond market index or their state bond rate. These rates are static and generally do not move with market conditions.
The sub-structure for interest rates further describes how the state administers its particular rate basis (i.e. true fixed rate, formula-based, tiered, percentage-based, or an otherwise variable rate), such as a tiered structure with rate discounts based upon loan term length, locality median household income, or other statistical measures. Formula-based rates establish a mathematical equation that utilizes various statistics and other data from the borrowing locality as inputs to determine a final rate. Further, some SRFs stipulate a standard percentage discount from a market or fixed base rate determined by borrower and project characteristics. There are also some SRF programs that retain a fair degree of administrative flexibility and discretion in establishing the final rate with no explicit terms, which can best be categorized as a variable sub-structure that allows them to customize rates for individual borrowers. Visuals with the percentage of states that utilize each general rate type (Figure 1) and sub-structure (Figure 2) for their SRFs are below.
Fig. 1
Fig. 2
Roughly two-thirds of all states have adopted a market rate approach for their SRF interest rates. Of all the rate subtypes, 50% of states have a percentage-based or variable structure based on the benchmark that is set. Of the percentage-based subtypes, there is commonly a general range of percentages that assessed rates may fall within. The range of variation in structures shows the large degree of discretion the SRF programs have in setting the final interest rate for each specific loan awarded.
In contrast to interest rates, fees exist to offset the actual administrative costs associated with loan origination and closing, or to support a specific program offered through the SRF or other eligible use of funds. Fees are generally assessed as either a flat percentage of principal at closing or rolled into the interest rate as an annual administrative fee. From the data analyzed, fees that are ongoing and included as part of the annual rate have a significantly higher overall impact on borrowers’ total costs. The use of these fees varies among the states, with some utilizing these funds to cover annual administrative program costs, and others establishing administrative fee reserve funds, holding the funds for future use in support of an SRF-eligible program or initiative, or utilizing a portion of the funds as additional program revenue and a source of available capital for loans.
In looking at available information on all DWSRF and CWSRF programs, there is a wide variation in total interest rates and fees. I’ve provided a few examples from state SRFs that illustrate how these policy choices impact borrowers. These particular programs presented outliers that demonstrated a comparatively higher or lower interest or fee assessment than the other programs, or were unique in how these borrowing costs were structured. Assuming a $5 million principal loan and a twenty-year repayment period and no additional rate subsidies or principal forgiveness, the total cost to the borrower can vary from $250,000 to $500,000 for the selected SRF programs, amounting to about a 5% to 10% difference in costs.
Fig. 3
Indiana: Indiana's SRF assesses its interest rate as a percentage of a market rate. The rate is described as 90% (or below) of the average 20-year AAA rated general obligation bond municipal market data. Available data at the time of this research suggests that the current rate for 20-year AAA general obligation debt is approximately 3.3%. At 90% of this benchmark, the rate would be approximately 2.97%, with a total interest cost of $1,637,164 over the life of a 20 year loan. The flat $1,000 origination fee is very minimal in comparison.
Iowa: Iowa's SRF programs offer a fixed 1.75% interest rate for standard 20-year and disadvantaged community loans, which results in much lower interest rate costs than in Indiana. However, there is a .5% origination fee and a .25% annual servicing fee for all construction loans, which in combination amount to a lifetime fee on the loan of $151,562. As mentioned previously, it appears that programs with an ongoing servicing or annual administration fee have significantly greater total fee costs.
Louisiana: Louisiana's interest rates can vary annually from 0% to market per the programs’ Intended Use Plans (IUPs), but a fixed rate within that range is established annually. The current interest rate is set at 1.95%. Their fee is a semi-annual payment of .5% of principal balance, resulting in a total fee of $225,207.
Montana: Montana assesses a fixed interest rate of 2.5%. Of all of the states offering a fixed rate, this was one of the highest. The state does not provide information on loan fees
in either the program IUPs or program website, so it’s not clear what the total borrowing cost would amount to. However, the 2.5% interest rate includes a 0.25% surcharge fee, and it’s possible this is the only fee the state charges.
New Hampshire: New Hampshire offers a tiered fixed rate system, with 20-year loan rates set at 2.536% -one of the higher fixed rates among all other fixed-rate states. There is also a 2% of principal balance fee paid at closing, which amounts to $100,000 on a $5M loan.
North Dakota: North Dakota offers a low 1.5% fixed rate for SRF loans. However, the fee structure is similar to that of Louisiana, with a .5% annual fee based on the outstanding principal balance.
Vermont: Vermont currently offers SRF loans at 0% interest. However, the state assesses fees annually, which makes them similar to an interest rate and can range from 0% to 2.75% of outstanding principal balance. The IUPs state that disadvantaged communities will receive a minimum of a 1.5% reduction in the fee. The state’s use of fees may be important for covering administrative support for the program, as well as helping it set aside funds for project development and engineering costs that might be ineligible uses of other revenue sources. In addition, the agency can set fees to zero for particular purposes, one example being projects benefiting Lake Champlain.
A unique feature of the state revolving funds is that states have a lot of freedom to customize loan terms to individual borrowers. Thus, this analysis can’t fairly convey all the ways that SRF administrators can work with a loan applicant to adjust terms so they fit what the applicant is capable of doing with respect to repayment. Nonetheless, I think it’s helpful to provide a comprehensive look at how interest rates and fees - generally affect borrowing costs, because it might help SRF administrators understand if small changes in their programs could meaningfully help borrowers without affecting the sustainability of their state’s SRF accounts. Given that these policy choices can have a 5-10% total increase on borrowing costs, I thought it was worth a review.
Especially in a time of rising market rates, states with an SRF interest rate tied to the market should really consider whether that approach is necessary, or whether fixed rate approaches could help limit total borrowing costs for loan recipients, particularly those serving overburdened, underserved communities. SRF accounts can still grow over time without needing to be in sync with the bond market, and given the complex application and project requirements for SRF loans, now is a better time than ever to look at using interest rates to make the SRFs more useful to borrowers that can least afford Wall Street’s costs.
In part two of this series, I will take a closer look at the implications of how loan funds are disbursed after award, and how making interest-only payments on funds drawn during the construction phase of a project can make a significant difference on total borrowing costs once the loan principal has entered repayment. Understanding the impact of interest rates, particularly compounding interest, is crucial for borrowers and policymakers in making informed financial decisions and ensuring sustainable water infrastructure development.