Optimizing Interest Rate, Loan Term, and Fee Policies in SRF Financing

State Revolving Fund (SRF) programs play a key role in providing financial assistance for essential water infrastructure projects in the U.S. These programs aim to strike a delicate balance by providing affordable funding and financing to communities while also maintaining the financial sustainability of the funds. To achieve this balance, states implement various policies around interest rates, loan terms, and fees. These policies shape the affordability of SRF loans and determine how effectively the funds can revolve to support future projects. 

Here, we briefly describe these policies and provide background information to help potential SRF applicants understand the nuances of award packages for which they may be eligible and to help state SRF program staff compare their offerings with those of other states. Additional information on these policy decisions can be found in our interest rate policy brief.

For further information on interest rates, see also our following blogs: 

• Variation in Borrowing Costs Between Different States’ Drinking Water and Clean Water State Revolving Fund Programs

• Probably More Than You Want to Know About SRF Compound Interest

1. Interest Rate Policies

Fixed vs. Market-Based Rates

Interest rates represent the percentage of a loan's principal that a lender charges as the cost of borrowing, typically expressed on an annual basis. SRF programs are required under 40 CFR 35.3525(a)(1) to make loans at or below market rates. By offering loans with interest rates at or below market rates, the SRFs aim to enhance access to low-cost financing, particularly for small and historically under-resourced communities and critical infrastructure projects. There are different methodologies for setting interest rates, however, and states have multiple decisions to make in determining how to set their interest rates for SRF loans. 

When setting interest rates, states must decide between fixed and market-based interest rate structures. Fixed rates remain constant throughout the loan term, providing predictability for borrowers. This stability can be particularly appealing for smaller or under-resourced communities, as it shields them from market volatility. However, fixed rates can expose SRF programs to risks if market rates rise, potentially undermining the program's long-term sustainability.

On the other hand, market-based rates fluctuate based on benchmarks like municipal bond indices (e.g., see Thomson Reuters Municipal Market Data (MMD) rate) or state bond rates. These rates are more reflective of current economic conditions and are particularly advantageous for leveraged SRF programs, where market-based approaches ensure the program can meet its debt obligations. While borrowers may face variability with market-based rates, these structures generally align well with the financial sustainability goals of SRF programs, by reflecting market rates.

Within these broad categories, states often adopt substructures to tailor interest rates to community and project characteristics. Options include:

• True Fixed Rates: A single, unchanging rate over the loan term.

• Tiered Systems: Rates that vary based on borrower income, project type, or other factors.

• Formula-Based Structures: Rates calculated using demographic or financial data.

• Percentage Discounts: Rates offered at a percentage below a market benchmark.

States commonly offer discounted rates to state-defined disadvantaged communities (DACs) or high-priority projects. For example, Michigan employs a tiered system with rates as low as 1% for communities the state defines as significantly overburdened, while Indiana offers 0% interest for projects replacing lead service lines. These tailored approaches balance accessibility for borrowers with the fiscal health of the SRF program.

Recommendations for Interest Rate Policies

To optimize interest rate policies, states should consider:

1. Adopting flexible interest rate structures: Use tiered or formula-based rates to better serve diverse communities and projects.

2. Incentivizing key projects: Offer lower rates for urgent needs, green infrastructure, and state-defined DACs.

3. Ensuring transparency: Clearly communicate rate-setting processes to build trust and support borrowers’ long-term financial planning.

4. Reviewing policies regularly: Periodically adjust rates to respond to economic changes and program needs.

2. Loan Term Policies

Standard and Extended Terms

Loan terms define the repayment period, directly influencing the affordability of SRF loans. Standard terms for DWSRF and CWSRF programs are typically 20 to 30 years, but many states offer extended terms of up to 40 years for state-defined DACs or projects with long useful lives (see 42 U.S.C. §300j-12(f)). For example, Michigan extends terms to 40 years for DACs, easing repayment pressures for these communities. While some communities may need longer terms in order to repay loan portions of their financing, extended terms may lead to higher overall costs if interest rates are not adequately discounted.

In addition to standard and extended terms, some states provide shorter-term loans for pre-construction activities like planning, design, or asset management. California and Nebraska, for instance, offer 5- to 10-year loans for these activities, ensuring communities can undertake crucial preparatory work that takes less time than typical construction projects. 

Recommendations for Loan Term Policies

To enhance loan term policies, states should consider:

1. Customizing terms: Align loan durations with the financial capacities of underserved communities.

2. Financing pre-construction needs with short-term loans: Offer shorter terms for planning activities.

3. Pairing loan terms with rates: Consider reducing interest rates for long-term loans for communities in need to avoid excessive repayment costs.

3. Loan Fee Policies

Types of Loan Fees

Loan fees are financial charges imposed by states to cover administrative and operational costs associated with managing the SRF’s loan program. These fees help ensure the long-term sustainability of the program by supporting activities like loan origination, program oversight, and compliance monitoring. While these fees are necessary for program management, they can also impact the affordability of loans for borrowers. These fees are typically charged either as a percentage of the principal at closing or are incorporated into the interest rate as an annual administrative fee. Ongoing fees included in the annual rate have a significantly greater impact on borrowers’ total costs than fees charged as a flat percentage of the principal at closing. 

While fees may be necessary for program management, they can significantly impact total borrowing costs. States must carefully balance fees with interest rates to ensure affordability for borrowers while ensuring sufficient resources to maintain a well-run program. 

Recommendations for Loan Fee Policies

Effective loan fee policies should consider:

1. Ensuring transparency: Clearly communicate fee structures and their implications for borrowers.

2. Minimizing financial burdens on stressed communities: Use set-aside allowances or alternative revenue sources to lower or eliminate fees for financially burdened communities.

---

Interest rates, loan terms, and fee policies are critical tools for shaping the success of SRF programs. By adopting transparent, flexible, and community-centered approaches, states can ensure these funds remain accessible to all borrowers while maintaining their revolving nature. Thoughtful policy design will enable SRF programs to continue financing vital water infrastructure projects, promoting expanded access to durable infrastructure in communities across the nation.