Sound Financial Bancorp, Inc. (SFBC)

Item 7.    MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This discussion and analysis reviews our consolidated financial statements and other relevant statistical data and is intended to enhance your understanding of our financial condition and results of operations. The information in this section has been derived from the Consolidated Financial Statements and notes thereto that appear in "Part II. Item 8. Financial Statements and Supplementary Data" of this Form 10-K. The information contained in this section should be read in conjunction with these Consolidated Financial Statements and notes and the business and financial information provided in this Form 10-K.

Overview

Our principal business consists of attracting retail and commercial deposits from the general public and investing those funds, along with borrowed funds, in loans secured by first and second mortgages on one-to-four family residences (including home equity loans and lines of credit), commercial and multifamily real estate, construction and land, and consumer and commercial business loans. Our commercial business loans include unsecured lines of credit and secured term loans and lines of credit secured by inventory, equipment and accounts receivable. We also offer a variety of secured and unsecured consumer loan products, including manufactured home loans, floating home loans, automobile loans, boat loans and recreational vehicle loans. As part of our business, we focus on residential mortgage loan originations, a portion of which we sell to Fannie Mae and other investors and the remainder of which we retain for our loan portfolio consistent with our asset/liability objectives. We sell loans which conform to the underwriting standards of Fannie Mae (“conforming”) in which we retain the servicing of the loan in order to maintain the direct customer relationship and to generate noninterest income. Residential loans which do not conform to the underwriting standards of Fannie Mae (“non-conforming”), are either held in our loan portfolio or sold with servicing released. We originate and retain a significant amount of commercial real estate loans, including those secured by owner-occupied and nonowner-occupied commercial real estate, multifamily properties and mobile home parks, and construction and land development loans.

We originated $39.9 million and $53.1 million of one-to-four family loans during the years ended December 31, 2024 and 2023, respectively. We had no purchases of one-to-four family loans during the years ended December 31, 2024 and 2023. During those two years, we sold $14.2 million and $17.1 million, respectively, of one-to-four family loans.

Our strategic plan targets consumers, small- and medium-sized businesses, and professionals within our market area for loans and deposits. In managing the size and concentrations of our loan portfolio, we focus on including a significant amount of commercial business and commercial and multifamily real estate loans. A significant portion of our commercial business and commercial and multifamily real estate loans have adjustable rates, higher yields and shorter terms, and higher credit risk than traditional residential fixed-rate mortgage loans.

In 2022 and continuing into 2023, due to a generally illiquid jumbo loan market for residential mortgage loans, we retained a higher proportion of these jumbo loans than historically, resulting in commercial business and commercial and multifamily real estate loans making up a lower percentage of our overall portfolio. Our commercial loan portfolio (commercial and multifamily real estate and commercial business loans) totaled $387.1 million or 42.9% of our loan portfolio at December 31, 2024, up slightly from $336.0 million or 37.5% of our loan portfolio at December 31, 2023. Our consumer loan portfolio, which includes manufactured and floating homes and other consumer loans, increased to $145.3 million or 16.2% of our loan portfolio at December 31, 2024, from $130.9 million or 14.6% of our loan portfolio at December 31, 2023.

Our operating revenues are derived principally from earnings on interest-earning assets, service charges and fees, and gains on the sale of loans. The ongoing high interest rate environment is expected to continue exerting downward pressure on our net gain on sale of loans, and keeping borrowing costs elevated. This may adversely affect our net interest income and net interest margin in 2025. While the high interest rate environment also impacts the interest expense paid on our deposits, potentially reducing net interest margin as deposit rates rise, we expect the rates earned on our loan portfolio to continue repricing at higher yields. To meet our funding requirements, we rely on various sources, including deposits (both retail and brokered), FHLB advances, borrowings through the Federal Reserve, and payments received on loans and securities. We offer a diverse range of deposit accounts to our customers, including savings, money market, NOW (negotiable order of withdrawal), interest-bearing and noninterest-bearing demand accounts, as well as certificates of deposit. This variety of deposit accounts provides customers with flexibility in terms of interest rates and terms to suit their financial preferences.

The provision for credit losses, or the release of such provision, is essential for maintaining the ACL at a level sufficient to cover estimated lifetime credit losses in our loan portfolio, including unfunded loan commitments. An increase in our loan portfolio or a rise in estimated lifetime credit losses may result in additional provisions for credit losses, thereby decreasing net income. However, improvements in loan risk ratings, increased property values, or recoveries of previously charged-off amounts may partially or fully offset the required increase in the ACL due to factors such as loan growth or an increase in

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estimated lifetime losses on loans and unfunded loan commitments. We recorded a release of provision for credit losses of $120 thousand for the year ended December 31, 2024, consisting of a release of provision for credit losses on loans of $161 thousand and a provision for credit losses on unfunded commitments of $41 thousand, compared to a release of provision for credit losses of $273 thousand for the year ended December 31, 2023, consisting of a provision for credit losses on loans of $564 thousand and a release of the provision for credit losses on unfunded commitments of $837 thousand.

Effective January 1, 2023, the Company adopted ASU No. 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, also known as CECL. CECL replaces the existing incurred loss impairment methodology that recognizes credit losses when a probable loss has been incurred with new methodology where loss estimates are based upon lifetime expected credit losses. As a result of the change in methodology from the incurred loss model to the CECL model, on January 1, 2023, the Company recorded a one-time upward adjustment to the ACL for loans of $760 thousand and to the ACL for unfunded loan commitments of $695 thousand, and an after-tax decrease to opening retained earnings of $1.1 million. See “Note 2—Accounting Pronouncements Recently Issued or Adopted” in the Notes to Consolidated Financial Statements contained in “Part II. Item 8. Financial Statements and Supplementary Data” of this report on Form 10-K.

Our noninterest expenses consist primarily of salaries, employee benefits, incentive pay, expenses for occupancy, online and mobile services, marketing, professional fees, data processing, charitable contributions, FDIC deposit insurance premiums and regulatory expenses. Salaries and benefits consist primarily of the salaries paid to our employees, payroll taxes, directors' fees, retirement expenses, share-based compensation and other employee benefits. Occupancy expenses, which are the fixed and variable costs of buildings and equipment, consist primarily of lease payments, property taxes, depreciation charges, maintenance and the cost of utilities.

Recent Accounting Standards

For a discussion of recent accounting standards, see "Note 2—Accounting Pronouncements Recently Issued or Adopted" in the Notes to Consolidated Financial Statements contained in "Part II. Item 8. Financial Statements and Supplementary Data" of this report on Form 10-K.

Critical Accounting Estimates

We prepare our consolidated financial statements in accordance with GAAP. In doing so, we must make estimates and assumptions. Our critical accounting estimates are those estimates that involve a significant level of uncertainty at the time the estimate was made, and changes in the estimate that are reasonably likely to occur from period to period, or use of different estimates that we reasonably could have used in the current period, would have a material impact on our financial condition or results of operations. Accordingly, actual results could differ materially from our estimates. We base our estimates on past experience and other assumptions that we believe are reasonable under the circumstances, and we evaluate these estimates on an ongoing basis. Facts and circumstances that could affect these judgments include, but are not limited to, changes in interest rates, changes in the performance of the economy and changes in the financial condition of borrowers. We have reviewed our critical accounting estimates with the audit committee of our Board of Directors.

See "Note 1—Organization and Significant Accounting Policies" in the Notes to Consolidated Financial Statements contained in "Part II. Item 8. Financial Statements and Supplementary Data" of this report on Form 10-K for a summary of significant accounting policies.

Allowance for Credit Losses. The level of the ACL is established using the CECL approach for financial instruments measured at amortized cost and other commitments to extend credit. CECL requires the immediate recognition of estimated credit losses expected to occur over the estimated remaining life of the asset. The forward-looking concept of CECL requires loss estimates to consider historical experience, current conditions and reasonable and supportable forecasts. The ACL consists of two elements: (1) identification of loans that do not share risk characteristics with collectively evaluated loan pools, which are individually analyzed for expected credit loss and (2) establishment of an ACL for collectively evaluated loan pools based upon loans that share similar risk characteristics.

We estimate the ACL using relevant and reliable information from internal and external sources, related to past events, current conditions, and a reasonable and supportable forecast. Historical credit loss experience for both the Company and segment-specific peers provides the basis for the estimate of expected credit losses. Segments are based upon federal call report segmentation.

We continuously evaluate and update our critical accounting estimates and judgments based on changing conditions. As part of our ongoing enhancement of the ACL methodology, during the year ended December 31, 2024, we made additional improvements to the loss model. This included a qualitative adjustment related to our loan review process and how we adjust

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for the qualitative component using a scorecard to guide management’s analysis. This change in the ACL is considered a change in accounting estimate as per ASC 250-10 provisions, where adjustments should be made prospectively.

While our policies and procedures used to estimate the ACL, as well as the resulting provision for credit losses reported on the Consolidated Statements of Income, are reviewed periodically by regulators, model validators and internal audit, they are necessarily approximate and imprecise. There are factors beyond our control, such as changes in projected economic conditions, real estate markets or particular industry conditions, which may materially impact asset quality and the adequacy of the ACL and thus the resulting provision for credit losses.

Our ACL analysis is prepared utilizing a qualitative scorecard framework, which establishes bounds for the estimation of loss between a minimum (“Low Watermark”) and a maximum (“High Watermark”) for each segment. The Low Watermark indicates zero credit losses. The High Watermark is established by utilizing the same historical loss rate model used to establish modified loss rates, assuming a worse-case economic scenario. Risk levels are categorized as minor, moderate, major, no change, and improvement, segmenting the gap between the Low Watermark and High Watermark.

In evaluating the results of the sensitivity analysis, the qualitative factor adjustment provided the largest change in the ACL. If all qualitative factors were adjusted from the base model to the High Watermark, the estimated ACL on loans would increase to $25.2 million (2.82%). However, considering all relevant information, management estimated pooled loan losses to range between the base model of $6.1 million (0.69%) and, with all qualitative factors assigned a minor risk level, $12.5 million (1.40%). This evaluation included an assessment of changes to business risks and alignment with the Company’s overall strategy and objectives. Management determined that the Company’s overall strategy and objectives remained constant during the quarter compared to the look-back period. The historical look-back period and loss rate serve as the foundation of the ACL methodology, considering both our loss history and peer loss rates. No historical or recent experience has indicated notable deviations from management’s assessments.

Mortgage Servicing Rights.  We record MSRs on loans sold to Fannie Mae with servicing retained as well as for acquired servicing rights. We stratify our capitalized MSRs based on the type, term and interest rates of the underlying loans. MSRs are carried at fair value. The value is determined through a discounted cash flow analysis, which uses interest rates, prepayment speeds, weighted average life and delinquency rate assumptions as inputs. All of these assumptions require a significant degree of management judgment. If our assumptions prove to be incorrect, the value of our MSRs could be negatively impacted. We use a third party to assist us in the preparation of the analysis of the market value each quarter.

This analysis is conducted using a secondary valuation to assess the sensitivity of prepayment speeds and changes in market value due to fluctuations in the weighted average life. If interest rates were to increase, the prepayment speed of our MSR portfolio would decrease which would also lead to an increase in the weighted average life. Conversely, if interest rates were to decrease, the prepayment speed would increase and the weighted average life would decrease. We performed a sensitivity analysis utilizing two third-party valuations where we compared the assumptions within the models. Under a scenario of a decrease in the prepayment speed, an increase in the discount rate, and a decrease in the weighted average life of the MSR portfolio, the fair value of the MSR portfolio would decrease by approximately $420 thousand. No historical or recent experience has indicated notable deviations from management’s assessments.

Business and Operating Strategies and Goals

Our goal is to deliver returns to stockholders by increasing higher-yielding assets (including consumer, commercial and multifamily real estate and commercial business loans), increasing lower-cost core deposit balances, managing expenses, managing problem assets and exploring expansion opportunities. We seek to achieve these results by focusing on the following objectives:

Focusing on Asset Quality.  We believe that strong asset quality is a key to our long-term financial success. We are focused on monitoring existing performing loans, resolving nonperforming assets and selling foreclosed assets. Nonperforming assets were $7.5 million, or 0.75% of total assets, at December 31, 2024 compared to $4.1 million or 0.42% of total assets, at December 31, 2023. We continually seek to reduce the level of nonperforming assets through collections, modifications and sales of OREO. We also take proactive steps to resolve our non-performing loans, including negotiating payment plans, forbearances, loan modifications and loan extensions on delinquent loans when such actions have been deemed appropriate. Our goal is to maintain or improve upon our level of nonperforming assets by managing all segments of our loan portfolio in order to proactively identify and mitigate risk.

Improving Earnings by Expanding Product Offerings. We intend to prudently maintain the percentage of our assets consisting of higher-yielding commercial and multifamily real estate and commercial business loans, which offer higher risk-adjusted returns, shorter maturities and more sensitivity to interest-rate fluctuations than one-to-four family mortgage loans, while

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maintaining our focus on residential lending. In addition, we continue to focus on consumer products, such as floating and manufactured home loans. With our long experience and expertise in residential lending we believe we can be effective in capturing mortgage banking opportunities and grow consumer deposits. We continue to develop correspondent relationships to sell nonconforming mortgage loans servicing released. We also intend to selectively add products to further diversify revenue sources and to capture more of each client's banking relationship by offering additional services. We continue to refine our products and services for additional business and to automate services, such as automating consumer loan originations this past year, in an effort to improve customer service. We intend to further build relationships with medium and small businesses through new and improving existing service offerings, including remote deposit.

Emphasizing Lower Cost Core Deposits to Manage the Funding Costs of Our Loan Growth.  Our strategic focus is to emphasize total relationship banking with our clients to internally fund our loan growth. We also emphasize reducing wholesale funding sources, including FHLB advances, through the continued growth of core deposits. We believe that a continued focus on client relationships will help increase the level of core deposits and retail certificates of deposit from consumers and businesses in our market area. We intend to increase demand deposits by growing retail and business banking relationships. New technology and services are generally reviewed for business development and cost saving opportunities. We continue to experience growth in client use of our online and mobile banking services, which allow clients to conduct a full range of services on a real-time basis, including balance inquiries, transfers and electronic bill paying, while providing our clients greater flexibility and convenience in conducting their banking. In addition to our retail branches, we believe we maintain state of the art technology-based products, such as business cash management, business remote deposit products, business and consumer mobile banking applications and consumer remote deposit products. Total deposits increased to $837.8 million at December 31, 2024, from $826.5 million at December 31, 2023, with core deposits, which we define as our non-time deposit accounts and time deposit accounts of less than $250 thousand, increasing $15.3 million to $731.0 million at December 31, 2024, from $715.7 million at December 31, 2023.

Maintaining Our Client Service Focus.  Exceptional service, local involvement (including volunteering and contributing to the communities where we do business) and timely decision-making are integral parts of our business strategy. Our employees understand the importance of delivering exemplary customer service and seeking opportunities to build relationships with our clients to enhance our market position and add profitable growth opportunities. We compete with other financial service providers by relying on the strength of our customer service and relationship banking approach. We believe that one of our strengths is that our employees are also significant stockholders through our ESOP and 401(k) plans. We also offer incentives that are designed to reward employees for achieving high-quality client relationship growth.

Expanding Our Presence, Including Through Digital Channels and Streamlining Operations, Within Our Existing and Contiguous Market Areas and by Capturing Business Opportunities Resulting from Changes in the Competitive Environment.  We believe that opportunities currently exist within our market area to grow our franchise. We anticipate continued organic growth as the local economy and loan demand remain strong, through our marketing efforts and as a result of the opportunities created from the consolidation of financial institutions occurring in our market area. In addition, by delivering high-quality, client-focused products and services, we expect to attract additional borrowers and depositors and thus increase our market share and revenue generation. We continue to be disciplined as it pertains to future expansion, acquisitions and de novo branching focusing on the markets in Western Washington, which we know and understand.

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Comparison of Financial Condition at December 31, 2024 and December 31, 2023

General.  Total assets decreased by $1.6 million, or 0.2%, to $993.6 million at December 31, 2024, from $995.2 million at December 31, 2023. This decrease was primarily a result of lower balances of cash and cash equivalents and investment securities, offset by an increase in loans held-for-portfolio.

Cash and Securities.  Cash, cash equivalents, AFS securities and HTM securities decreased by $6.6 million, or 10.9%, to $53.6 million at December 31, 2024 compared to the prior year-end. Cash and cash equivalents decreased $6.0 million, or 12.2%, to $43.6 million at December 31, 2024 compared to the prior year-end due to the increase in loans held-for-portfolio and the payoff of FHLB advances, partially offset by an increase in deposits. AFS securities decreased $497 thousand, or 6.0%, to $7.8 million at December 31, 2024 from the 2023 year end, primarily due to regularly scheduled payments and maturities, and net unrealized losses resulting from the increases in market interest rates during the past 12 months. HTM securities totaled $2.1 million at December 31, 2024 and 2023, and consisted of municipal bonds and agency mortgage-backed securities.

Loans.  Loans held-for-portfolio increased $5.7 million, or 0.6%, to $901.8 million at December 31, 2024 from $896.2 million at December 31, 2023. Loans held-for-sale decreased to $487 thousand at December 31, 2024 from $603 thousand at December 31, 2023 primarily due to timing of originations.

The following table reflects the changes in the loan mix, excluding premiums and deferred fees, of our portfolio at December 31, 2024, as compared to December 31, 2023 (dollars in thousands):

Commercial and multifamily loans saw the largest increase, rising by $56.2 million, or 17.8%, primarily due to the conversion of completed construction loans to permanent financing. Floating home loans increased by $11.3 million, or 15.0%, while home equity loans grew by $3.6 million, or 15.7%, as homeowners utilized the equity in their homes. Manufactured home loans rose by $4.9 million, or 13.6%, reflecting affordability in the current market, internal efficiencies in loan processing, and successful

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marketing efforts. These increases were partially offset by declines in other loan categories. Construction and land loans experienced the largest decrease, declining by $53.7 million, or 42.3%, as completed construction loans paid off or converted to permanent financing, while new construction loans have not yet fully advanced. Commercial business loans decreased by $5.1 million, or 24.6%, due to lower outstanding balances on lines of credit and paydowns exceeding new originations. One-to-four family loans declined by $9.8 million, or 3.5%, as a result of elevated mortgage interest rates and a lower supply of housing. Additionally, other consumer loans decreased by $1.9 million, or 9.6%.

The increase in home equity loans was primarily driven by homeowners utilizing the equity in their homes, while the increase in commercial and multifamily loans was primarily due to the conversion of completed construction loans to permanent financing. The increase in manufactured and floating home loans can be attributed to the affordability of these homes in the current market, coupled with internal efficiencies in how we process these loans and successful marketing campaigns.These increases were partially offset by decreases in one-to-four family, construction and land, and commercial business loans. The decrease in construction and land loans was due to construction loans completing and paying off or converting to permanent financing, while new construction loans have not fully advanced. The decrease in commercial business loans were primarily from lower outstanding balances on lines of credit and paydowns exceeding new originations.

The loan portfolio remains well-diversified with commercial and multifamily real estate loans accounting for 41.2% of the portfolio, one-to-four family real estate loans, including home equity loans, accounting for approximately 32.9% of the portfolio and consumer loans, consisting of manufactured homes, floating homes, and other consumer loans, accounting for 16.2% of the total loan portfolio at December 31, 2024. Construction and land loans accounted for 8.1% of the portfolio and commercial business loans accounted for the remaining 1.7% of the portfolio at December 31, 2024.

Nonperforming Assets.  Nonperforming assets, comprised of nonperforming loans (nonaccrual loans and nonperforming modified loans to troubled borrowers) and OREO and repossessed assets, increased $3.4 million, or 81.3%, to $7.5 million, or 0.75% of total assets, at December 31, 2024 from $4.1 million, or 0.42% of total assets, at December 31, 2023.

The table below sets forth the amount of nonperforming assets at the dates indicated (dollars in thousands):

The increase in nonperforming assets primarily was due to the placement of an additional $9.3 million of loans on nonaccrual status, including a $3.7 million matured commercial real estate loan where the borrower is in the process of securing alternative financing, and a $2.4 million floating home loan, all of which are well secured. These additions were partially offset by payoffs totaling $4.2 million, the return of $784 thousand of loans to accrual status, charge-offs of $142 thousand, the sale of two OREO properties for $690 thousand, and regular loan payments. Our largest nonperforming loan relationship at December 31, 2024 was the $3.7 million commercial real estate loan noted above. In addition, there were eight manufactured home loans, one floating home loan, one business term, one commercial real estate, one home equity loan, one land loan, and five other consumer loans classified as nonperforming at December 31, 2024. Nonperforming loans were 0.83% of total loans at December 31, 2024, compared to 0.40% of total loans at December 31, 2023. We had no loans delinquent 90 days or more and still accruing at December 31, 2024 and 2023.

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Allowance for Credit Losses.  The following table reflects the adjustments in our ACL during the periods indicated (dollars in thousands):

The ACL for loans decreased $261 thousand, or 3.0%, to $8.5 million at December 31, 2024, from $8.8 million at December 31, 2023, while the ACL for unfunded loan commitments increased $41 thousand, or 21.2% to $234 thousand at December 31, 2024, from $193 thousand at December 31, 2023. The changes in the balances were primarily due to changes in the mix of the loan portfolio, enhancements to the loss model related to how we adjust for the qualitative component, including the utilization of a scorecard to drive managements analysis, and growth in our unfunded construction loan portfolio, which has a higher loss rate than our other loan portfolios. Expected loss estimates consider various factors, such as market conditions, borrower-specific information, projected delinquencies, and the impact of economic conditions on borrowers' ability to repay. See “Comparison of Results of Operations for the Years Ended December 31, 2024 and 2023 — Provision for Credit Losses.”

Mortgage Servicing Rights.  The fair value of MSRs was $4.8 million at December 31, 2024, compared to $4.6 million at December 31, 2023. We record MSRs on loans sold with servicing retained and upon acquisition of a servicing portfolio. MSRs are carried at fair value. If the fair value of our MSRs fluctuates significantly, our financial results could be materially impacted.

Deposits.Total deposits increased $11.3 million to $837.8 million at December 31, 2024, compared to the prior year-end. The increase in total deposits primarily was the result of a $52.0 million, or 33.8%, increase in money market accounts. Management attributes this increase primarily to interest rate sensitive clients moving a portion of their non-operating deposit balances from lower interest-bearing demand and savings accounts into higher interest-bearing money market accounts. Interest-bearing demand and saving accounts decreased $26.2 million, or 15.6%, and $8.2 million, or 11.8%, respectively, from December 31, 2023 to December 31, 2024. Certificate accounts decreased $12.1 million, or 3.9%, to $295.8 million at December 31, 2024, compared to the 2023 year-end, primarily due to a strategic decision to pay higher rates on money market accounts as opposed to certificate accounts. Noninterest-bearing demand accounts (excluding escrow accounts) increased $6.0 million, or 4.8%, in 2024, compared to 2023.

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A summary of deposit accounts with the corresponding weighted-average cost at December 31, 2024 and 2023 is presented below (dollars in thousands):

(1)Escrow balances shown in noninterest-bearing deposits on the Consolidated Balance Sheets.

Scheduled maturities of time deposits at December 31, 2024, are as follows (in thousands):

Savings, demand, and money market accounts have no contractual maturity. Certificates of deposit have maturities of five or less.

Deposit amounts in excess of $250,000 are not federally insured. As of December 31, 2024, uninsured deposits totaled $167.3 million, which represented 20.0% of total deposits, as compared to uninsured deposits of $140.1 million, or 17.0% of total deposits as of December 31, 2023. The aggregate amount of time deposits in denominations of more than $250,000 at December 31, 2024 and December 31, 2023, totaled $90.9 million and $88.3 million, respectively. The uninsured amounts are estimates based on the methodologies and assumptions used for the Bank’s regulatory reporting requirements.

Borrowings.  FHLB advances totaled $25.0 million at December 31, 2024, compared to $40.0 million at December 31, 2023. The decrease was due to the repayment of a $15.0 million FHLB advance that matured in November 2024. FHLB advances are primarily used to support organic loan growth and to maintain liquidity ratios in line with our asset/liability objectives. FHLB advances outstanding at December 31, 2024 had maturities ranging from early 2026 through early 2028. Subordinated notes, net totaled $11.8 million at December 31, 2024 and 2023. For additional information regarding our borrowings, see “Note 10—Borrowings, FHLB Stock and Subordinated Notes” in the Notes to Consolidated Financial Statements contained in “Part II. Item 8. Financial Statements and Supplementary Data” of this report on Form 10-K.

Stockholders' Equity.  Total stockholders’ equity increased $3.0 million, or 3.0%, to $103.7 million at December 31, 2024, from $100.7 million at December 31, 2023. This increase primarily reflects $4.6 million in net income for the year ended December 31, 2024, $390 thousand in share-based compensation, and $269 thousand in common stock options exercised, partially offset by the payment of cash dividends of $1.9 million to common stockholders, as well as unrealized gains on our securities portfolio resulting in other comprehensive income, net of tax, of $56 thousand, the repurchase of $65 thousand of common stock, and stock surrendered of $218 thousand to satisfy tax withholding obligations upon the vesting of restricted stock during the year ended December 31, 2024.

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Average Balances, Net Interest Income, Yields Earned and Rates Paid

The following table presents, for the periods indicated, the total dollar amount of interest income from average interest-earning assets and the resultant yields, as well as the interest expense on average interest-bearing liabilities, expressed both in dollars and rates. Income and yields on tax-exempt obligations have not been computed on a tax equivalent basis. All average balances are daily average balances. Nonaccrual loans have been included in the table as loans carrying a zero yield for the period they have been on nonaccrual (dollars in thousands).

(1) Calculated net of deferred loan fees, loan discounts and loans in process.

(2) Total funding is the sum of average interest-bearing liabilities and average noninterest-bearing deposits. The cost of total funding is calculated as annualized total interest expense divided by average total funding.

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Rate/Volume Analysis

The following table presents the dollar amount of changes in interest income and interest expense for major components of interest-earning assets and interest-bearing liabilities. It distinguishes between changes related to outstanding balances and changes due to interest rates. For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (i) changes in volume (i.e., changes in volume multiplied by old rate) and (ii) changes in rate (i.e., changes in rate multiplied by old volume). For purposes of this table, changes attributable to both rate and volume, which cannot be segregated, have been allocated proportionately to the change due to volume and the change due to rate (dollars in thousands).

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Comparison of Results of Operation for the Years Ended December 31, 2024 and 2023

General. Net income decreased $2.8 million, or 37.6%, to $4.6 million, or $1.80 per diluted common share, for the year ended December 31, 2024, compared to $7.4 million, or $2.86 per diluted common share, for the year ended December 31, 2023. The decrease was primarily a result of a $2.8 million decrease in net interest income, a $351 thousand decrease in noninterest income and a $153 thousand decrease in the release of credit losses, partially offset by a $555 thousand decrease in provision for income taxes.

Interest Income.  Interest income increased $6.8 million, or 13.4%, to $57.4 million for the year ended December 31, 2024, from $50.6 million for the year ended December 31, 2023, due to an increase in both the average balance of and yield earned on interest earning assets.

Interest income on loans increased $4.0 million, or 8.7%, to $50.5 million for the year ended December 31, 2024, compared to $46.5 million for the year ended December 31, 2023, driven by a higher average balance of total loans and a 29 basis points increase in the average yield on loans. The average balance of total loans was $896.7 million for the year ended December 31, 2024, compared to $870.2 million for the year ended December 31, 2023, resulting primarily from increased average balances in commercial and multifamily, home equity, and consumer loans. The average yield on total loans was 5.63% for the year ended December 31, 2024, compared to 5.34% for the year ended December 31, 2023. The average yield on total loans increased primarily due to variable rate loans adjusting to higher market interest rates and new loan originations at higher interest rates.

Interest income on the investment portfolio decreased $10 thousand, or 1.93%, to $508 thousand for the year ended December 31, 2024, compared to $518 thousand for the year ended December 31, 2023. The decrease was due to lower average balances, partially offset by higher average yields. The average yield on investments was 4.07% for the year ended December 31, 2024, compared to 3.79% for the year ended December 31, 2023, primarily due to the impact of rising rates.

Interest income on cash and cash equivalents increased $2.7 million, or 75.8%, to $6.4 million for the year ended December 31, 2024, compared to $3.6 million for the year ended December 31, 2023. The increase was due to higher average yields and higher average balances. The average yield on cash and cash equivalents was 5.12% for the year ended December 31, 2024, compared to 4.85% for the year ended December 31, 2023, primarily due to the impact of higher market interest rates during

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the year. The average balance of cash and cash equivalents was $124.3 million for the year ended December 31, 2024, compared to $74.7 million for the year ended December 31, 2023. The increase in cash and cash equivalents was primarily due to the increase in deposits, offset by an increase in loans held-for-portfolio and the payoff of one FHLB borrowing.

Interest Expense.  Interest expense increased $9.6 million, or 57.4%, to $26.4 million for the year ended December 31, 2024, from $16.8 million for the year ended December 31, 2023, as a result of an increase in the overall average balances and costs of deposits and borrowings.

Interest expense on deposits increased $9.9 million, or 70.3%, to $24.1 million for the year ended December 31, 2024, compared to $14.1 million for the year ended December 31, 2023. The increase was the result of an increase in the average balance of and rates paid on certificate accounts and savings and money market accounts, offset slightly by a $53.4 million decrease in the average balance of demand and NOW accounts. The average cost of total deposits, including noninterest bearing deposits, increased 95 basis points to 2.64% for the year ended December 31, 2024, from 1.69% for the year ended December 31, 2023.

Interest expense on borrowings, comprised solely of FHLB advances, was $1.6 million for the year ended December 31, 2024, compared to $2.0 million for the year ended December 31, 2023, reflecting the decreased use of FHLB advances to supplement our liquidity needs. The cost of FHLB advances decreased 12 basis points to 4.32% for the year ended December 31, 2024, compared to 4.44% for the year ended December 31, 2023. The average balance of FHLB advances was $37.6 million for the year ended December 31, 2024, compared to $44.0 million for the year ended December 31, 2023. Interest expense on subordinated notes was $672 thousand for both the year ended December 31, 2024 and the year ended December 31, 2023.

Net Interest Income.  Net interest income decreased $2.8 million, or 8.4%, to $31.0 million for the year ended December 31, 2024, from $33.9 million for the year ended December 31, 2023. Net interest margin was 3.00% and 3.53% for the year ended December 31, 2024 and 2023, respectively. The decrease in net interest income primarily resulted from an increase in the average balances of and rates paid on deposits and borrowings, partially offset by higher average balances and yields earned on interest-earning assets. The decrease in net interest margin primarily was due to funding costs increasing at a faster pace than the average yields earned on interest-earning assets and an increase in the average balance of interest earning assets.

During 2023, in response to inflation, the Federal Open Market Committee of the Federal Reserve (“FOMC”) increased the target range for the federal funds rate by 100 basis points to a range of 5.25% to 5.50%, where it remained until September 2024. In light of the progress on reducing inflation and after considering the balance of risks, the FOMC decided to lower the target range 50 basis points to 4.75% to 5.00% during 2024. The FOMC further lowered the target range by an additional 50 basis points, to 4.25% to 4.50%, in November of 2024.

Provision for Credit Losses.

The following table reflects the components of the provision for (release of) credit losses during the periods indicated (dollars in thousands):

The change in the (release of) provision for credit losses for 2024 from 2023 resulted primarily from changes in methodology used to reserve for credit losses. During the year ended December 31, 2024, the release of credit losses on loans primarily related to lower reserves on our residential loan portfolio due to qualitative adjustments for changes in concentration, the value of underlying collateral, and market conditions, as well as lower reserves in our floating home sub-segment of other consumer loans within our quantitative analysis and in our qualitative analysis related to market conditions and value of underlying collateral, as economic conditions have improved. These decreases were partially offset by growth in the loan portfolio, an increase in nonaccrual loans and the weighted average life of the portfolio, and enhancements to the loss model related to how we adjust for the qualitative component. The provision for credit losses on unfunded loan commitments during the year related to an increase in the reserve rate due to model enhancements, partially offset by a decrease in unfunded loan commitments at December 31, 2024, compared to the prior year-end. Net charge-offs for the year ended December 31, 2024 totaled $100 thousand, compared to net charge-offs of $163 thousand for the year ended December 31, 2023.

Under CECL, the provision for credit losses for the year ended December 31, 2024 reflects assumptions related to our forecast concerning the economic environment as a result of local, national and global events. In addition, expected loss estimates

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consider various factors, including customer-specific information, changes in risk ratings, projected delinquencies, and the impact of economic conditions on borrowers' ability to repay.

While we believe the estimates and assumptions used in our determination of the adequacy of the ACL are reasonable, there can be no assurance that such estimates and assumptions will not be proven incorrect in the future, or that the actual amount of future provisions will not exceed the amount of past provisions or that any increased provisions that may be required will not have a material adverse impact on our financial condition and results of operations. A deterioration in national and local economic conditions due to such factors as inflation, a recession or slowed economic growth, among others, may lead to a material increase in the provision for credit losses, which could have a material adverse impact on our financial condition and results of operations. In addition, the determination of the amount of our ACL is subject to review by bank regulators as part of the routine examination process, which may result in the adjustment to the ACL based upon their judgment of information available to them at the time of their examination.

Noninterest Income.  Noninterest income decreased $351 thousand, or 7.0%, to $4.7 million for the year ended December 31, 2024, compared to $5.0 million for the year ended December 31, 2023, as reflected below (dollars in thousands):

The decrease in noninterest income during the year ended December 31, 2024, compared to 2023 primarily was due to a $554 thousand decrease in earnings on BOLI, reflecting death benefits paid under our BOLI policies in the prior year. Additionally, an $82 thousand decrease in net gain on sale of loans resulted from lower mortgage activity, with loans sold during 2024 totaling $14.2 million compared to $19.2 million sold during 2023, and a $61 thousand decline in mortgage servicing income was due to the servicing portfolio shrinking at a faster rate than we were able to replace loans, due to the current interest rate environment. These decreases were partially offset by a $93 thousand increase in service charges and fee income resulting from increases in late fees on loans, interchange income and income related to a new, multi-year agreement with our debit card provider that was effective in 2024. Further, a $215 thousand upward adjustment in the fair value of MSRs was due to a change in prepayment speeds, servicing costs, and discount rate. Finally, other income increased $38 thousand due to an insurance claim on equipment in 2024.

Noninterest Expense.  Noninterest expense was $30.1 million during the years ended December 31, 2024 and 2023, as reflected below (dollars in thousands):

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The increase in noninterest expenses during the year ended December 31, 2024 compared to the year ended December 31, 2023, was primarily driven by a $455 thousand increase in salaries and benefits, largely due to higher incentive compensation expenses, increased medical expenses, and higher commission expenses. This increase was partially offset by a decrease in salaries and contractor expenses. In addition, regulatory assessments increased $99 thousand as a result of a higher deposit insurance assessment rate introduced at the beginning of 2023 and the Company’s increased asset size. Partially offsetting these increases were several decreases in noninterest expenses. Operations expenses decreased by $201 thousand mainly due to reductions in office expenses, loan origination fees, travel expenses, state and local taxes, and charitable contributions, partially offset by higher professional fees (tax and consulting) and increased costs related to deposit products, especially debit card processing expenses. Data processing expenses decreased $162 thousand due to lower costs associated with the Company’s core processor and occupancy expenses decreased by 145 thousand primarily because of fully amortized leasehold improvements.

The efficiency ratio for the year ended December 31, 2024 was 84.50%, compared to 77.54% for the year ended December 31, 2023. The deterioration in the efficiency ratio was due to lower interest income and noninterest income in 2024.

Income Tax Expense. The provision for income taxes decreased $555 thousand, or 35.6% to $1.0 million for the year ended December 31, 2024, compared to $1.6 million for the year ended December 31, 2023 due to lower pre-tax income. The effective tax rates for the years ended December 31, 2024 and 2023 were 17.8% and 17.3%, respectively. The effective tax rate was higher in 2024 as a result of nontaxable income related to the BOLI death benefit received in prior year.

Capital and Liquidity

Capital. Stockholders’ equity totaled $103.7 million at December 31, 2024 and $100.7 million at December 31, 2023. In addition to net income of $4.6 million, other sources of capital during 2024 included $390 thousand related to stock-based compensation and $269 thousand in proceeds from stock option exercises. Uses of capital during 2024 included $56 thousand of other comprehensive income, net of tax, $1.9 million of dividends paid on common stock, $65 thousand of stock repurchases and $218 thousand of stock surrendered to satisfy tax withholding obligations upon the vesting of restricted stock awards.

We paid quarterly dividends aggregating $0.76 per common share during the year ended December 31, 2024 and quarterly dividends aggregating $0.74 per common share during the year ended December 31, 2023. This equates to a dividend payout ratio of 42.0% in 2024 and 25.7% in 2023. The Company expects to continue its current practice of paying quarterly cash dividends on its common stock, subject to the Board of Directors’ discretion to modify or terminate this practice at any time and for any reason. Assuming continued payment of cash dividends during 2025 at the current quarterly dividend rate of $0.19 per share, our total dividend paid each quarter would be approximately $488 thousand based on the number of our outstanding shares at December 31, 2024. The dividends, if any, we may pay in the future may be limited as more fully discussed under “Business—How We Are Regulated—Limitations on Dividends and Stock Repurchases” contained in Item 1, Part I of this Form 10-K.

Stock Repurchase Plans. From time to time, our board of directors has authorized stock repurchase plans. In general, stock repurchase plans allow us to proactively manage our capital position and return excess capital to stockholders. Shares purchased under such plans may also provide us with shares of common stock necessary to satisfy obligations related to stock compensation awards. In January 2024, the Board of Directors approved a stock repurchase program authorizing the Company to purchase up to $1.5 million of the Company’s issued and outstanding common stock over a period of 12 months which expired on January 26, 2025. The Board did not extend the stock repurchase plan that expired on January 26, 2025, nor did it adopt a new stock repurchase plan. See “Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities” contained in Item 5, Part II of this Form 10-K for additional information relating to stock repurchases.

Liquidity. Liquidity measures the ability to meet current and future cash flow needs as they become due. The liquidity of a financial institution reflects its ability to meet loan requests, to accommodate possible outflows in deposits and to take advantage of favorable movements in market interest rates. The ability of a financial institution to meet its current financial obligations is a function of its balance sheet structure, its ability to liquidate assets and its access to alternative sources of funds. The objective of our liquidity management is to manage cash flows and liquidity reserves so that they are adequate to fund our operations and to meet obligations and other commitments on a timely basis and at a reasonable cost. We seek to achieve this objective and ensure that funding needs are met by maintaining an appropriate level of liquid funds through asset/liability management, which includes managing the mix and time to maturity of financial assets and financial liabilities on our balance sheet. Our liquidity position is enhanced by our ability to raise additional funds as needed in the wholesale markets.

Asset liquidity is provided by liquid assets which are readily marketable or pledgeable or which will mature in the near future. Liquid assets generally include cash, interest-bearing deposits in banks, securities available for sale, maturities and cash flows

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from securities, sales of fixed rate residential mortgage loans in the secondary market and federal funds sold. Liability liquidity generally is provided by access to funding sources which include core deposits and advances from the FHLB and other borrowing relationships with third party financial institutions.

Our liquidity position is continuously monitored and adjustments are made to the balance between sources and uses of funds as deemed appropriate. Liquidity risk management is an important element in our asset/liability management process. We regularly model liquidity stress scenarios to assess potential liquidity outflows or funding problems resulting from economic disruptions, volatility in the financial markets, unexpected credit events or other significant occurrences deemed problematic by management. These scenarios are incorporated into our contingency funding plan, which provides the basis for the identification of our liquidity needs.

As of December 31, 2024, we had $51.4 million in cash, cash equivalents and AFS securities, and $487 thousand in loans held-for-sale. At December 31, 2024, we had the ability to borrow up to $172.3 million in FHLB advances (in addition to FHLB advances outstanding at that date) and up to $20.8 million through the Federal Reserve's discount window, in each case subject to certain collateral requirements. We had $25.0 million in outstanding advances with the FHLB at December 31, 2024 and no outstanding borrowings with the Federal Reserve at December 31, 2024. We also had available $20.0 million of credit facilities with other financial institutions, with no balance outstanding at December 31, 2024. Subject to market conditions, we expect to utilize these borrowing facilities from time to time in the future to fund loan originations and deposit withdrawals, to satisfy other financial commitments, repay maturing debt and to take advantage of investment opportunities to the extent feasible. As of December 31, 2024, management is not aware of any events that are reasonably likely to have a material adverse effect on our liquidity, capital resources or operations. In addition, management is not aware of any regulatory recommendations regarding liquidity that would have a material adverse effect on us. For additional details, see “Note 10—Borrowings, FHLB Stock and Subordinated Notes” in the Notes to Consolidated Financial Statements contained in “Item 8. Financial Statements and Supplementary Data” of this Form 10-K.

In the ordinary course of business, we enter into contractual obligations and have additional commitments to make future payments. These include payments related to (i) short and long-term borrowings (Note 10—Borrowings, FHLB Stock and Subordinated Notes), (ii) time deposits with stated maturity dates (Note 9—Deposits) (iii) operating leases (Note 12—Leases) and (iv) commitments to extend credit and standby letters of credit (Note 18—Commitments and Contingencies).

We incur capital expenditures on an ongoing basis to expand and improve our product offerings, enhance and modernize our technology infrastructure, and to introduce new technology-based products to compete effectively in our markets. We evaluate capital expenditure projects based on a variety of factors, including expected strategic impacts (such as forecasted impact on revenue growth, productivity, expenses, service levels and customer retention) and our expected return on investment. The amount of capital investment is influenced by, among other things, current and projected demand for our services and products, cash flow generated by operating activities, cash required for other purposes and regulatory considerations. Based on current capital allocation objectives, there are no projects scheduled for capital investments in premises and equipment during the year ending December 31, 2024 that would materially impact liquidity.

Sound Financial Bancorp is a separate legal entity from Sound Community Bank and must provide for its own liquidity. In addition to its own operating expenses (many of which are paid to Sound Community Bank), Sound Financial Bancorp is responsible for paying for any stock repurchases, dividends declared to its stockholders, interest and principal on outstanding holding company indebtedness, and other general corporate expenses.

Sound Financial Bancorp is a holding company and does not conduct operations; its sources of liquidity are generally dividends up-streamed from Sound Community Bank, interest on investment securities, if any, and borrowings from outside sources. Banking regulations may limit the dividends that may be paid to Sound Financial Bancorp by Sound Community Bank. See “Business — How We Are Regulated — Limitations on Dividends and Stock Repurchases” contained in Item 1, Part I of this Form 10-K.

In 2020, the Company completed a private placement of $12.0 million in aggregate principal of subordinated notes resulting in net proceeds, after placement fees and offering expenses, of approximately $11.6 million. The Company contributed $5.5 million of the net proceeds from the sale of the subordinated notes to the Bank and retained the remaining net proceeds to be used for general corporate purposes. At December 31, 2024, Sound Financial Bancorp, on an unconsolidated basis, had $1.3 million in cash, noninterest-bearing deposits and liquid investments generally available for its cash needs.

See also the “Consolidated Statements of Cash Flows” included in “Item 8. Financial Statements and Supplementary Data” of this Form 10-K, for additional information regarding our sources and use of funds.

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Regulatory Capital. Sound Community Bank is subject to minimum capital requirements imposed by regulations of the FDIC. Capital adequacy requirements are quantitative measures established by regulation that require Sound Community Bank to maintain minimum amounts and ratios of capital. Based on its capital levels at December 31, 2024, Sound Community Bank exceeded these requirements at that date. Consistent with our goals to operate a sound and profitable organization, our policy is for Sound Community Bank to maintain a "well-capitalized" status under the prompt corrective action capital categories of the FDIC.

Beginning January 2020, the Bank elected to use the CBLR framework. A bank that elects to use the CBLR framework as provided for in the Economic Growth, Regulatory Relief and Consumer Protection Act will generally be considered "well-capitalized" and to have met the risk-based and leverage capital requirements of the capital regulations if it has a leverage ratio greater than 9.0%. At December 31, 2024, the Bank’s CBLR was 10.60%, which exceeded the minimum requirements. For additional details, see “Note 16—Capital” in the Notes to Consolidated Financial Statements contained in "Item 8. Financial Statements and Supplementary Data" and "Item 1. Business—How We Are Regulated—Regulation of Sound Community Bank—Capital Rules" of this Form 10-K.

For a bank holding company with less than $3.0 billion in assets, the capital guidelines apply on a bank-only basis and the Federal Reserve expects the holding company's subsidiary banks to be "well-capitalized" under the prompt corrective action regulations. If Sound Financial Bancorp were subject to regulatory guidelines for bank holding companies with $3.0 billion or more in assets, at December 31, 2024, Sound Financial Bancorp would have exceeded all regulatory capital requirements. The estimated CBLR calculated for Sound Financial Bancorp at December 31, 2024 was 9.56%.

Item 7.    MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This discussion and analysis reviews our consolidated financial statements and other relevant statistical data and is intended to enhance your understanding of our financial condition and results of operations. The information in this section has been derived from the Consolidated Financial Statements and footnotes thereto that appear in "Part II. Item 8. Financial Statements and Supplementary Data" of this Form 10-K. The information contained in this section should be read in conjunction with these Consolidated Financial Statements and footnotes and the business and financial information provided in this Form 10-K.

Overview

Our principal business consists of attracting retail and commercial deposits from the general public and investing those funds, along with borrowed funds, in loans secured by first and second mortgages on one-to-four family residences (including home equity loans and lines of credit), commercial and multifamily real estate, construction and land, and consumer and commercial business loans. Our commercial business loans include unsecured lines of credit and secured term loans and lines of credit secured by inventory, equipment and accounts receivable. We also offer a variety of secured and unsecured consumer loan products, including manufactured home loans, floating home loans, automobile loans, boat loans and recreational vehicle loans. As part of our business, we focus on residential mortgage loan originations, a portion of which we sell to Fannie Mae and other investors and the remainder of which we retain for our loan portfolio consistent with our asset/liability objectives. We sell loans which conform to the underwriting standards of Fannie Mae (“conforming”) in which we retain the servicing of the loan in order to maintain the direct customer relationship and to generate noninterest income. Residential loans which do not conform to the underwriting standards of Fannie Mae (“non-conforming”), are either held in our loan portfolio or sold with servicing released. We originate and retain a significant amount of commercial real estate loans, including those secured by owner-occupied and nonowner-occupied commercial real estate, multifamily properties and mobile home parks, and construction and land development loans.

We originated $53.1 million and $125.6 million of one-to-four family residential mortgage loans during the years ended December 31, 2023 and 2022, respectively. We had no purchases of one-to-four family residential mortgage loans during the years ended December 31, 2023 and 2022. During those two years, we sold $17.1 million and $20.3 million, respectively, of one-to-four family residential mortgage loans.

Our strategic plan targets consumers, small- and medium-size businesses, and professionals in our market area for loans and deposits. In managing the size of, and concentrations within, our loan portfolio we typically focus on including a significant amount of commercial business and commercial and multifamily real estate loans. A significant portion of our commercial business and commercial and multifamily real estate loans have adjustable rates, higher yields and shorter terms, and higher credit risk than traditional residential fixed-rate mortgage loans. During 2022 and continuing through 2023, however, due to a generally illiquid jumbo loan market for residential mortgage loans, we retained a higher proportion of these jumbo loans than we have historically, resulting in commercial business and commercial and multifamily real estate loans making up a lower percentage of our overall portfolio. Our commercial loan portfolio (commercial and multifamily real estate and commercial business loans) totaled $336.0 million or 37.5% of our loan portfolio at December 31, 2023, down slightly from $337.2 million or 38.9% of our loan portfolio at December 31, 2022. Our consumer loan portfolio, which includes manufactured and floating homes and other consumer loans, increased to $130.9 million or 14.6% of our loan portfolio at December 31, 2023, from $119.3 million or 13.8% of our loan portfolio at December 31, 2022.

Our operating revenues are derived principally from earnings on interest-earning assets, service charges and fees, and gains on the sale of loans. The ongoing high interest rate environment is expected to continue to exert downward pressure on our net gain on sale of loans, as well as keep borrowing costs elevated, which may adversely affect our net interest income and net interest margin in 2024. To meet our funding requirements, we rely on various sources, including deposits (both retail and brokered), advances from the Federal Home Loan Bank (“FHLB”), borrowings through the Federal Reserve, and payments received on loans and securities. We offer a diverse range of deposit accounts to our customers, including savings, money market, NOW (negotiable order of withdrawal), interest-bearing and noninterest-bearing demand accounts, as well as certificates of deposit. This variety of deposit accounts provides customers with flexibility in terms of interest rates and terms to suit their financial preferences.

The provision for credit losses, or the release of such provision, is essential for establishing the ACL at a level sufficient to cover estimated lifetime credit losses in our loan portfolio, including unfunded loan commitments. An increase in our loan portfolio or a rise in estimated lifetime credit losses may result in additional provisions for credit losses, thereby decreasing net income. However, improvements in loan risk ratings, increased property values, or recoveries of previously charged-off amounts may partially or fully offset the required increase in the ACL due to factors such as loan growth or an increase in estimated lifetime losses on loans and unfunded loan commitments.

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We recorded a release of provision for credit losses of $273 thousand for the year ended December 31, 2023, consisting of a provision for credit losses on loans of $564 thousand and a release of credit losses on unfunded commitments of $837 thousand, compared to a provision of $1.2 million for the year ended December 31, 2022. The provision for credit losses on loans primarily relates to the mix of the loan portfolio and improved credit quality, partially offset by the increase in the balance of the loan portfolio and adjustments applied to certain loan portfolios within our forecast related to interest rate risk. The release of credit losses on unfunded loan commitments related to construction advances funding and moving into the ACL for loans. The increase in construction advances in the loans held-for-portfolio balance were offset by declines in our commercial construction portfolio as projects were completed.

Effective January 1, 2023, the Company adopted ASU No. 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, also known as CECL. CECL replaces the existing incurred loss impairment methodology that recognizes credit losses when a probable loss has been incurred with new methodology where loss estimates are based upon lifetime expected credit losses. As a result of the change in methodology from the incurred loss model to the CECL model, on January 1, 2023, the Company recorded a one-time upward adjustment to the ACL for loans of $760 thousand and to the ACL for unfunded loan commitments of $695 thousand, and an after-tax decrease to opening retained earnings of $1.1 million. See “Note 2—Accounting Pronouncements Recently Issued or Adopted” in the Notes to Consolidated Financial Statements contained in “Part II. Item 8. Financial Statements and Supplementary Data” of this report on Form 10-K.

Our noninterest expenses consist primarily of salaries, employee benefits, incentive pay, expenses for occupancy, online and mobile services, marketing, professional fees, data processing, charitable contributions, FDIC deposit insurance premiums and regulatory expenses. Salaries and benefits consist primarily of the salaries paid to our employees, payroll taxes, directors' fees, retirement expenses, share-based compensation and other employee benefits. Occupancy expenses, which are the fixed and variable costs of buildings and equipment, consist primarily of lease payments, property taxes, depreciation charges, maintenance and the cost of utilities.

Recent Accounting Standards

For a discussion of recent accounting standards, see "Note 2—Accounting Pronouncements Recently Issued or Adopted" in the Notes to Consolidated Financial Statements contained in "Part II. Item 8. Financial Statements and Supplementary Data" of this report on Form 10-K.

Critical Accounting Estimates

We prepare our consolidated financial statements in accordance with GAAP. In doing so, we must make estimates and assumptions. Our critical accounting estimates are those estimates that involve a significant level of uncertainty at the time the estimate was made, and changes in the estimate that are reasonably likely to occur from period to period, or use of different estimates that we reasonably could have used in the current period, would have a material impact on our financial condition or results of operations. Accordingly, actual results could differ materially from our estimates. We base our estimates on past experience and other assumptions that we believe are reasonable under the circumstances, and we evaluate these estimates on an ongoing basis. Facts and circumstances that could affect these judgments include, but are not limited to, changes in interest rates, changes in the performance of the economy and changes in the financial condition of borrowers. We have reviewed our critical accounting estimates with the audit committee of our Board of Directors.

See "Note 1—Organization and Significant Accounting Policies" in the Notes to Consolidated Financial Statements contained in "Part II. Item 8. Financial Statements and Supplementary Data" of this report on Form 10-K for a summary of significant accounting policies.

Allowance for Credit Losses. Effective January 1, 2023, we maintain an ACL in accordance with ASC 326. The ACL is measured using the CECL approach for financial instruments measured at amortized cost and other commitments to extend credit. CECL requires the immediate recognition of estimated credit losses expected to occur over the estimated remaining life of the asset. The forward-looking concept of CECL requires loss estimates to consider historical experience, current conditions and reasonable and supportable forecasts. The ACL consists of two elements: (1) identification of loans that do not share risk characteristics with collectively evaluated loan pools are individually analyzed for expected credit loss and (2) establishment of an ACL for collectively evaluated loan pools based upon loans that share similar risk characteristics.

We estimate the ACL using relevant and reliable information from internal and external sources, related to past events, current conditions, and a reasonable and supportable forecast. The ACL is measured on a collective (segment) basis when similar risk characteristics exist. Historical credit loss experience for both the Company and segment-specific peers provides the basis for the estimate of expected credit losses. Segments are based upon federal call report segmentation.

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We evaluate our critical accounting estimates and judgments on an ongoing basis and update them as necessary based on changing conditions. As part of our continuous enhancement to the ACL methodology, during the year ended December 31, 2023, an assessment of the loss rates utilized for each segment was performed and updated to use peer loss rates. Additionally, we enhanced the inputs related to our reasonable and supportable forecast through the inclusion of a quantitative model as part of our forecast which replaced a previous qualitative method. This change in the ACL is considered a change in accounting estimate as per ASC 250-10 provisions, where adjustments should be made prospectively.

While our policies and procedures used to estimate the ACL, as well as the resulting provision for credit losses reported in the Consolidated Statements of Income, are reviewed periodically by regulators, model validators and internal audit, they are necessarily approximate and imprecise. There are factors beyond our control, such as changes in projected economic conditions, real estate markets or particular industry conditions which may materially impact asset quality and the adequacy of the ACL and thus the resulting provision for credit losses.

This analysis is prepared utilizing a qualitative scorecard framework, which establishes bounds for the estimation of loss between zero (“Low Watermark”) and a maximum loss rate (“High Watermark”) for each segment. The Low Watermark is indicative of zero credit losses. The High Watermark is established by utilizing the same historical loss rate model used to establish modified loss rates, which included assuming a worse-case economic environment into the existing model. Risk levels categorized as minor, moderate, major, no change, and improvement, segment the gap between the Low Watermark and High Watermark. In evaluating the results from the sensitivity analysis, the sensitivity by qualitative factor adjustment provided the largest change in the ACL. If all qualitative factors were adjusted from the base model to the High Watermark, the estimated ACL on loans would increase to $32.8 million (3.28%). However, after thorough consideration of all relevant information, management assessed our current and forecasted conditions to estimate pooled loan losses to fall between the base model of $6.7 million (0.75%) and if all qualitative factors were assigned a minor risk level of $15.4 million (1.72%). This evaluation included an assessment of changes to business risks and alignment with the Company’s strategy and objectives. Management determined that the overall strategy and objectives of the Company did not deviate during the quarter compared to the look-back period. The historical look-back period and loss rate serve as the foundation of the ACL methodology, considering both our loss history and a group of peers’ loss rate. There is no historical or recent experience indicating notable variances from management’s assessments.

Mortgage Servicing Rights.  We record MSRs on loans sold to Fannie Mae with servicing retained as well as for acquired servicing rights. We stratify our capitalized MSRs based on the type, term and interest rates of the underlying loans. MSRs are carried at fair value. The value is determined through a discounted cash flow analysis, which uses interest rates, prepayment speeds and delinquency rate assumptions as inputs. All of these assumptions require a significant degree of management judgment. If our assumptions prove to be incorrect, the value of our MSRs could be negatively impacted. We use a third party to assist us in the preparation of the analysis of the market value each quarter.

This analysis is prepared utilizing an interest rate shock of +/- 300 basis points to determine the sensitivity of the prepayment speeds and the change in market value as a result of changes to the weighted average life. If interest rates were to decrease by 300 basis points the prepayment speed of our variable rate portfolio would increase at a faster pace than if interest rates were to increase 300 basis points, while our fixed portfolio would have a smaller change in the prepayment speeds with the same change in rates. In a +/- 300 basis point rate shock, the weighted average life would fluctuate between 7.98 years and 6.12 years, respectively. Additionally, the model utilizes a High Value, Medium Value and Low Value to determine the discount rate used in to the estimate of fair value of the MSR portfolio. Management elected to apply the High Value based on prior comparison of separate third-party pricing services that closely aligned with that valuation. If the entire portfolio were estimated using the Low Value, the fair value of the MSR portfolio would decrease by approximately $663 thousand. There is no historical or recent experience indicating notable variances from management’s assumptions.

Business and Operating Strategies and Goals

Our goal is to deliver returns to stockholders by increasing higher-yielding assets (including consumer, commercial and multifamily real estate and commercial business loans), increasing lower-cost core deposit balances, managing expenses, managing problem assets and exploring expansion opportunities. We seek to achieve these results by focusing on the following objectives:

Focusing on Asset Quality.  We believe that strong asset quality is a key to our long-term financial success. We are focused on monitoring existing performing loans, resolving nonperforming assets and selling foreclosed assets. Nonperforming assets were $4.1 million, or 0.42% of total assets, at December 31, 2023 compared to $3.6 million or 0.37% of total assets, at December 31, 2022. We continually seek to reduce the level of nonperforming assets through collections, modifications and sales of OREO. We also take proactive steps to resolve our non-performing loans, including negotiating payment plans, forbearances, loan modifications and loan extensions on delinquent loans when such actions have been deemed appropriate. Our goal is to

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maintain or improve upon our level of nonperforming assets by managing all segments of our loan portfolio in order to proactively identify and mitigate risk.

Improving Earnings by Expanding Product Offerings. We intend to prudently maintain the percentage of our assets consisting of higher-yielding commercial and multifamily real estate and commercial business loans, which offer higher risk-adjusted returns, shorter maturities and more sensitivity to interest-rate fluctuations than one-to-four family mortgage loans, while maintaining our focus on residential lending. In addition, we continue to focus on consumer products, such as floating and manufactured home loans. With our long experience and expertise in residential lending we believe we can be effective in capturing mortgage banking opportunities and grow consumer deposits. We continue to develop correspondent relationships to sell nonconforming mortgage loans servicing released. We also intend to selectively add products to further diversify revenue sources and to capture more of each client's banking relationship by offering additional services. We continue to refine our products and services for additional business and to automate services, such as automating consumer loan originations this past year, in an effort to improve customer service. We intend to further build relationships with medium and small businesses through new and improving existing service offerings, including remote deposit.

Emphasizing Lower Cost Core Deposits to Manage the Funding Costs of Our Loan Growth.  Our strategic focus is to emphasize total relationship banking with our clients to internally fund our loan growth. We also emphasize reducing wholesale funding sources, including FHLB advances, through the continued growth of core deposits. We believe that a continued focus on client relationships will help increase the level of core deposits and retail certificates of deposit from consumers and businesses in our market area. We intend to increase demand deposits by growing retail and business banking relationships. New technology and services are generally reviewed for business development and cost saving opportunities. We continue to experience growth in client use of our online and mobile banking services, which allow clients to conduct a full range of services on a real-time basis, including balance inquiries, transfers and electronic bill paying, while providing our clients greater flexibility and convenience in conducting their banking. In addition to our retail branches, we maintain state of the art technology-based products, such as business cash management, business remote deposit products, business and consumer mobile banking applications and consumer remote deposit products. Total deposits increased to $826.5 million at December 31, 2023, from $808.8 million at December 31, 2022. However, core deposits, which we define as our non-time deposit accounts and time deposit accounts of less than $250 thousand, decreased $30.0 million to $715.7 million at December 31, 2023, from $745.7 million at December 31, 2022. As a result of the decreased liquidity from core deposits, we increased our rates paid on certificates of deposit and borrowed against our FHLB lines of credit.

Maintaining Our Client Service Focus.  Exceptional service, local involvement (including volunteering and contributing to the communities where we do business) and timely decision-making are integral parts of our business strategy. Our employees understand the importance of delivering exemplary customer service and seeking opportunities to build relationships with our clients to enhance our market position and add profitable growth opportunities. We compete with other financial service providers by relying on the strength of our customer service and relationship banking approach. We believe that one of our strengths is that our employees are also significant stockholders through our ESOP and 401(k) plans. We also offer incentives that are designed to reward employees for achieving high-quality client relationship growth.

Expanding Our Presence, Including Through Digital Channels and Streamlining Operations, Within Our Existing and Contiguous Market Areas and by Capturing Business Opportunities Resulting from Changes in the Competitive Environment.  We believe that opportunities currently exist within our market area to grow our franchise. We anticipate continued organic growth as the local economy and loan demand remains strong, through our marketing efforts and as a result of the opportunities created from the consolidation of financial institutions occurring in our market area. In addition, by delivering high-quality, client-focused products and services, we expect to attract additional borrowers and depositors and thus increase our market share and revenue generation. We continue to be disciplined as it pertains to future expansion, acquisitions and de novo branching focusing on the markets in Western Washington, which we know and understand.

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Comparison of Financial Condition at December 31, 2023 and December 31, 2022

General.  Total assets increased by $18.9 million, or 1.9%, to $995.2 million at December 31, 2023, from $976.4 million at December 31, 2022. The increase was primarily a result of an increase in loans held-for-portfolio, partially offset by lower balances in cash and cash equivalents and decreases in investment securities.

Cash and Securities.  Cash, cash equivalents, AFS securities and HTM securities decreased by $10.1 million, or 14.4%, to $60.1 million at December 31, 2023 compared to the prior year. Cash and cash equivalents decreased $8.1 million, or 14.1%, to $49.7 million at December 31, 2023 compared to the prior year-end due to the increase in loans held-for-portfolio exceeding increases in deposits and the deployment of excess cash earning a nominal yield into higher earning loans and investments. AFS securities decreased $1.9 million, or 18.8%, to $8.3 million at December 31, 2023 from the year end 2022, primarily due to the maturity of $1.6 million in treasury securities in the first quarter of 2023, regularly scheduled payments and maturities, and net unrealized losses resulting from the increases in market interest rates during the past 12 months. HTM securities totaled $2.2 million at December 31, 2023 and 2022, and consisted of municipal bonds and agency mortgage-backed securities.

Loans.  Loans held-for-portfolio increased $28.6 million, or 3.3%, to $896.2 million at December 31, 2023 from $867.6 million at December 31, 2022, with increases across all loan categories, excluding commercial business loans. The increase in loans held-for-portfolio primarily resulted from focused marketing campaigns, increased utilization of digital marketing tools and the addition of experienced lending staff, which resulted in continued strong loan demand, as well as slower prepayments. Loans held-for-sale increased to $603 thousand at December 31, 2023 from zero at December 31, 2022 primarily due to timing of originations.

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The following table reflects the changes in the loan mix, excluding premiums and deferred fees, of our portfolio at December 31, 2023, as compared to December 31, 2022 (dollars in thousands):

The increase in one-to-four family loans was partially driven by an increase in short-term bridge loans and related party loans, while the increase in home equity loans was primarily driven by homeowners utilizing the equity in their homes. The increase in manufactured home loans can be attributed to the affordability of these homes in the current market, coupled with internal efficiencies in how we process these loans. The increase in other consumer loans was a result of high demand attributable to successful marketing campaigns.We also experienced increases in our commercial and multifamily real estate and floating homes loan portfolios. These increases were partially offset by a decrease in commercial business loans, which decreased $3.1 million or 13.1% to $20.7 million, primarily from lower outstanding balances on lines of credit and paydowns exceeding new originations.

The loan portfolio remains well-diversified with commercial and multifamily real estate loans accounting for 35.2% of the portfolio, one-to-four family real estate loans, including home equity loans, accounting for approximately 33.8% of the portfolio and consumer loans, consisting of manufactured homes, floating homes, and other consumer loans, accounting for 14.6% of the total loan portfolio at December 31, 2023. Construction and land loans accounted for 14.1% of the portfolio and commercial business loans accounted for the remaining 2.3% of the portfolio at December 31, 2023.

Nonperforming Assets.  Nonperforming assets, which are comprised of nonperforming loans (nonaccrual loans and nonperforming modified loans to troubled borrowers) and OREO and repossessed assets, increased $514 thousand, or 14.2%, to $4.1 million, or 0.42% of total assets, at December 31, 2023 from $3.6 million, or 0.37% of total assets, at December 31, 2022.

The table below sets forth the amount of nonperforming assets at the dates indicated (dollars in thousands):

The increase in nonperforming assets primarily was due to a $2.1 million business term loan, $649 thousand in four one-to-four family real estate loans, and $142 thousand in two manufactured home loans being placed on nonaccrual status, partially offset by the payoff of $1.5 million in nonperforming one-to-four family real estate loans related to a single borrower, the write-off of one residential property for $84 thousand, and other payoffs and normal amortization. Our largest nonperforming loan relationship at December 31, 2023 consisted of one business term loan totaling $2.1 million, which was well secured by collateral currently listed for sale and we expect to be repaid in full. In addition, there were five manufactured home loans, two home equity loans, two other consumer loans, and nine additional one-to-four family loans classified as nonperforming at December 31, 2023. Nonperforming loans were 0.40% of total loans at December 31, 2023, compared to 0.34% of total loans at December 31, 2022. We had no loans delinquent 90 days or more and still accruing at December 31, 2023 and 2022.

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Allowance for Credit Losses.  The following table reflects the adjustments in our ACL during the periods indicated (dollars in thousands):

The ACL for loans increased $1.2 million, or 15.3%, to $8.8 million at December 31, 2023, from $7.6 million at December 31, 2022, while the ACL for unfunded loan commitments decreased $143 thousand, or 42.4% to $193 thousand at December 31, 2023, from $335 thousand at December 31, 2022. The change in methodology from the incurred loss model to the CECL model on January 1, 2023, resulted in a one-time upward adjustment to the ACL for loans of $760 thousand and an ACL for unfunded loan commitments of $695 thousand. Furthermore, construction advances outstanding at December 31, 2022, and funded during the year ended December 31, 2023, led to a reduction in the ACL for unfunded loan commitments and an increase in the ACL for loans. As we continued to refine our model for calculating the ACL, the loss rates utilized in the model standardized through the use of additional peer group data, with the largest adjustments seen in the construction segments. The model incorporates economic variables, the impact of inflation and adjustments to the forecast related to the interest rate environment, applied to certain loan portfolios, which contributed to the change in the provision for credit losses from December 31, 2022. See “Comparison of Results of Operations for the Years Ended December 31, 2023 and 2022 — Provision for Credit Losses.”

Mortgage Servicing Rights.  The fair value of MSRs was $4.6 million at December 31, 2023, compared to $4.7 million at December 31, 2022. We record MSRs on loans sold with servicing retained and upon acquisition of a servicing portfolio. MSRs are carried at fair value. If the fair value of our MSRs fluctuates significantly, our financial results could be materially impacted.

Deposits. Total deposits increased $17.8 million, or 2.2%, to $826.5 million at December 31, 2023 from $808.8 million at December 31, 2022. The increase in deposits was a result of an increase in certificate accounts and money market accounts, including $5.0 million of brokered deposits. These funds were primarily used to fund organic loan growth. However, this increase was partially offset by decreases in noninterest-bearing and interest-bearing demand accounts and savings accounts as interest rate sensitive clients moved a portion of their non-operating deposit balances from lower costing deposits, including noninterest-bearing deposits, into higher costing money market and time deposits. Noninterest-bearing demand balances (including escrow accounts) decreased $46.5 million, or 26.8%, to $126.7 million at December 31, 2023, compared to $173.2 million at December 31, 2022. Noninterest-bearing (including escrow accounts) deposits represented 15.3% of total deposits at December 31, 2023, compared to 21.4% at December 31, 2022.

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A summary of deposit accounts with the corresponding weighted-average cost at December 31, 2023 and 2022 is presented below (dollars in thousands):

(1)Escrow balances shown in noninterest-bearing deposits on the Consolidated Balance Sheets.

Scheduled maturities of time deposits at December 31, 2023, are as follows (in thousands):

Savings, demand, and money market accounts have no contractual maturity. Certificates of deposit have maturities of five years or less.

Deposit amounts in excess of $250,000 are not federally insured. As of December 31, 2023, uninsured deposits totaled $140.1 million, which represented 17.0% of total deposits, as compared to uninsured deposits of $161.9 million, or 20.0% of total deposits as of December 31, 2022. The aggregate amount of time deposits in denominations of more than $250,000 at December 31, 2023 and December 31, 2022, totaled $88.3 million and $56.1 million, respectively. The uninsured amounts are estimates based on the methodologies and assumptions used for the Bank’s regulatory reporting requirements. The decrease in total uninsured deposits primarily related to the increased customer use of deposit insurance products, such as ICS® (Insured Cash Sweep) and CDARS® (Certificate of Deposit Registry Service), that reduced the level of uninsured deposits following the failures of some banks during 2023.

Borrowings.  FHLB advances decreased to $40.0 million at December 31, 2023, while reaching a high of $92.0 million during 2023, as we utilized our FHLB line of credit to offset fluctuations in deposits for funding needs.  There were $43.0 million of FHLB advances at December 31, 2022. FHLB advances are primarily used to support organic loan growth and to maintain liquidity ratios in line with our asset/liability objectives. FHLB advances outstanding at December 31, 2023 had maturities ranging from late 2024 through early 2028.  Subordinated notes, net totaled $11.7 million at December 31, 2023 and 2022. For additional information regarding our borrowings, see “Note 10—Borrowings, FHLB Stock and Subordinated Notes” in the Notes to Consolidated Financial Statements contained in “Part II. Item 8. Financial Statements and Supplementary Data” of this report on Form 10-K.

Stockholders' Equity.  Total stockholders’ equity increased $2.9 million, or 3.0%, to $100.7 million at December 31, 2023, from $97.7 million at December 31, 2022. This increase primarily reflects $7.4 million in net income for the year ended December 31, 2023 and unrealized gains on our securities portfolio resulting in other comprehensive income, net of tax, of $129 thousand, partially offset by the payment of cash dividends of $1.9 million to common stockholders and the repurchase of $2.1 million of common stock during the year ended December 31, 2023. In addition, stockholders’ equity at December 31, 2023 was negatively impacted by the adoption of CECL in the first quarter of 2023, which resulted in an after-tax decrease to opening retained earnings of $1.1 million.

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Average Balances, Net Interest Income, Yields Earned and Rates Paid

The following table presents, for the periods indicated, the total dollar amount of interest income from average interest-earning assets and the resultant yields, as well as the interest expense on average interest-bearing liabilities, expressed both in dollars and rates. Income and yields on tax-exempt obligations have not been computed on a tax equivalent basis. All average balances are daily average balances. Nonaccrual loans have been included in the table as loans carrying a zero yield for the period they have been on nonaccrual (dollars in thousands).

(1) Calculated net of deferred loan fees, loan discounts and loans in process.

(2) Total funding is the sum of average interest-bearing liabilities and average noninterest-bearing deposits. The cost of total funding is calculated as annualized total interest expense divided by average total funding.

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Rate/Volume Analysis

The following schedule presents the dollar amount of changes in interest income and interest expense for major components of interest-earning assets and interest-bearing liabilities. It distinguishes between changes related to outstanding balances and changes due to interest rates. For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (i) changes in volume (i.e., changes in volume multiplied by old rate) and (ii) changes in rate (i.e., changes in rate multiplied by old volume). For purposes of this table, changes attributable to both rate and volume, which cannot be segregated, have been allocated proportionately to the change due to volume and the change due to rate (dollars in thousands).

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Comparison of Results of Operation for the Years Ended December 31, 2023 and 2022

General. Net income decreased $1.4 million, or 15.5%, to $7.4 million, or $2.86 per diluted common share, for the year ended December 31, 2023, compared to $8.8 million, or $3.35 per diluted common share, for the year ended December 31, 2022. The decrease was primarily a result of a $1.4 million decrease in net interest income and a $2.3 million increase in noninterest expense, partially offset by a $1.4 million decrease in provision for credit losses and a $424 thousand increase in noninterest income.

Interest Income.  Interest income increased $10.8 million, or 27.2%, to $50.6 million for the year ended December 31, 2023, from $39.8 million for the year ended December 31, 2022, primarily due to higher average loan balances, a 47 basis point increase in the average loan yield, a 105 basis point increase in the average yield earned on investments, and a 373 basis point increase in cash and cash equivalents, partially offset by a lower average balance of investments, cash and cash equivalents.

Interest income on loans increased $8.3 million, or 21.7%, to $46.5 million for the year ended December 31, 2023, compared to $38.2 million for the year ended December 31, 2022, driven by higher average total loans and a 47 basis points increase in the average yield on loans. The average balance of total loans was $870.2 million for the year ended December 31, 2023, compared to $783.4 million for the year ended December 31, 2022, resulting from increased average balances related to all loan categories, except commercial business loans. The average yield on total loans was 5.34% for the year ended December 31, 2023, compared to 4.87% for the year ended December 31, 2022. The average yield on total loans increased primarily due to variable rate loans adjusting to higher market interest rates and new loan originations at higher interest rates.

Interest income on the investment portfolio increased $135 thousand, or 35.25%, to $518 thousand for the year ended December 31, 2023, compared to $383 thousand for the year ended December 31, 2022. The increase was due to higher average yields, partially offset by lower average balances. The average yield on investments was 3.79% for the year ended December 31, 2023, compared to 2.74% for the year ended December 31, 2022, primarily due to the impact of rising rates.

Interest income on cash and cash equivalents increased $2.4 million, or 193.2%, to $3.6 million for the year ended December 31, 2023, compared to $1.2 million for the year ended December 31, 2022. The increase was due to higher average yields, partially offset by lower average balances. The average yield on cash and cash equivalents was 4.85% for the year ended December 31, 2023, compared to 1.12% for the year ended December 31, 2022, primarily due to the impact of rising rates.

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Interest Expense.  Interest expense increased $12.3 million, or 272.4%, to $16.8 million for the year ended December 31, 2023, from $4.5 million for the year ended December 31, 2022, primarily as a result of an increase in the average balances and costs of deposits and borrowings

Interest expense on deposits increased $11.2 million, or 379.2%, to $14.1 million for the year ended December 31, 2023, compared to $3.0 million for the year ended December 31, 2022. The increase was primarily the result of an increase in the average balance of certificate accounts, as well as higher average rates paid on all interest-bearing deposits, partially offset by a $84.7 million decrease in the average balance of interest-bearing deposits other than certificate accounts. The average cost of total deposits increased 132 basis points to 1.69% for the year ended December 31, 2023, from 0.37% for the year ended December 31, 2022.

Interest expense on borrowings, comprised solely of FHLB advances, was $2.0 million for the year ended December 31, 2023, compared to $878 thousand for the year ended December 31, 2022, reflecting the increased use of FHLB advances to supplement our liquidity needs. The cost of FHLB advances increased 122 basis points to 4.44% for the year ended December 31, 2023, compared to 3.22% for the year ended December 31, 2022. The average balance of FHLB advances was $44.0 million for the year ended December 31, 2023, compared to $27.3 million for the year ended December 31, 2022. Interest expense on subordinated notes was $672 thousand for both the year ended December 31, 2023 and the year ended December 31, 2022.

Net Interest Income.  Net interest income decreased $1.4 million, or 4.1%, to $33.9 million for the year ended December 31, 2023, from $35.3 million for the year ended December 31, 2022. Net interest margin was 3.53% and 3.89% for the year ended December 31, 2023 and 2022, respectively. The decrease in net interest income primarily resulted from an increase in the average balances of and rates paid on deposits and borrowings, partially offset by higher average balances and yields earned on interest-earning assets. The decrease in net interest margin primarily was due to funding costs increasing at a faster pace than the average yields earned on interest-earning assets and an increase in the average balance of interest earning assets.

Since March 2022, in response to inflation, the Federal Open Market Committee of the Federal Reserve has increased the target range for the federal funds rate by 525 basis points, including 100 basis points during 2023, to a range of 5.25% to 5.50% as of December 31, 2023.

Provision for Credit Losses.

The following table reflects the components of the provision for (release of) credit losses during the periods indicated (dollars in thousands):

The change in the provision for (release of) credit losses for 2023 from 2022 resulted primarily from changes in methodology used to reserve for credit losses. The Company adopted the CECL standard as of January 1, 2023. All amounts prior to January 1, 2023 were calculated using the previously incurred loss methodology to compute our allowance for loan losses, which is not directly comparable to the new CECL methodology. During the year ended December 31, 2023, the provision for credit losses on loans primarily relates to the mix of the loan portfolio and improved credit quality, partially offset by the increase in the balance of the loan portfolio and adjustments applied to certain loan portfolios within our forecast related to interest rate risk. The release of credit losses on unfunded loan commitments resulted from a decrease in unfunded loan commitments at December 31, 2023, compared to the prior year-end. Net charge-offs for the year ended December 31, 2023 totaled $163 thousand, compared to net recoveries of $68 thousand for the year ended December 31, 2022.

Under CECL, the provision for credit losses for the year ended December 31, 2023 reflects assumptions related to our forecast concerning the economic environment as a result of local, national and global events. In addition, expected loss estimates consider various factors, including customer-specific information, changes in risk ratings, projected delinquencies, and the impact of economic conditions on borrowers' ability to repay.

While we believe the estimates and assumptions used in our determination of the adequacy of the ACL are reasonable, there can be no assurance that such estimates and assumptions will not be proven incorrect in the future, or that the actual amount of future provisions will not exceed the amount of past provisions or that any increased provisions that may be required will not have a material adverse impact on our financial condition and results of operations. A deterioration in national and local economic conditions due to such factors as inflation, a recession or slowed economic growth, among others, may lead to a

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material increase in the provision for credit losses, which could have a material adverse impact on our financial condition and results of operations. In addition, the determination of the amount of our ACL is subject to review by bank regulators as part of the routine examination process, which may result in the adjustment to the ACL based upon their judgment of information available to them at the time of their examination.

Noninterest Income.  Noninterest income increased $424 thousand, or 9.3%, to $5.0 million for the year ended December 31, 2023, as compared to $4.6 million for the year ended December 31, 2022, as reflected below (dollars in thousands):

The increase in noninterest income during the year ended December 31, 2023, compared to 2022 primarily was due to a $960 thousand increase in earnings on BOLI reflecting $567 thousand in death benefits paid under our BOLI policies and an increase in the cash surrender value due to recent price increases in the securities markets. Additionally, service fees and fee income increased $159 thousand, which included $66 thousand in miscellaneous income related to an agreement with Mastercard and an insurance settlement received during the second quarter of 2023 on a prior OREO property. These increases were partially offset by a $426 thousand downward adjustment in the fair value of MSRs due to higher market interest rates, a $206 thousand decrease in net gain on sale of loans resulting from lower mortgage activity and a $63 thousand decline in mortgage servicing income due to the size of the servicing portfolio shrinking at a faster rate than we are replacing the loans due to the current interest rate environment. Loans sold during the year ended December 31, 2023, totaled $19.2 million, compared to $20.9 million during the year ended December 31, 2022.

Noninterest Expense.  Noninterest expense increased $2.3 million, or 8.2%, to $30.1 million during the year ended December 31, 2023, compared to $27.8 million during the year ended December 31, 2022, as reflected below (dollars in thousands):

Salaries and benefits increased primarily due to higher wages, hiring for strategic initiatives, higher medical expenses and lower deferred compensation, partially offset by a decrease in incentive compensation and commissions related to a decline in loan origination activity during the year ended December 31, 2023 as compared to 2022. Operations expense increased primarily due to increases in various accounts including legal fees, audit fees, state and local taxes, charitable contributions, office expenses and costs related to our deposit products, specifically debit card processing expenses, partially offset by lower marketing costs, professional fees (tax and consulting) and loan origination fees. Regulatory assessments rose due to an increase in our deposit insurance assessment rate at the beginning of 2023 and our increased asset size. Data processing expense increased due to software-related costs for new technology being implemented at the Bank and higher processing charges related to a higher volume of transactional activity.

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The efficiency ratio for the year ended December 31, 2023 was 77.54%, compared to 69.83% for the year ended December 31, 2022, due to higher noninterest expense and lower overall revenue in 2023.

Income Tax Expense. The provision for income taxes decreased $511 thousand, or 24.7% to $1.6 million for the year ended December 31, 2023, compared to $2.1 million for the year ended December 31, 2022 due to lower pre-tax income. The effective tax rates for the years ended December 31, 2023 and 2022 were 17.3% and 19.1%, respectively. The effective tax rate was lower in 2023 as a result of nontaxable income related to the BOLI death benefit received during 2023.

Capital and Liquidity

Capital. Stockholders’ equity totaled $100.7 million at December 31, 2023 and $97.7 million at December 31, 2022. In addition to net income of $7.4 million, other sources of capital during 2023 included $129 thousand of other comprehensive income, net of tax, $395 thousand in proceeds from stock option exercises and $450 thousand related to stock-based compensation. Uses of capital during 2023 included $1.9 million of dividends paid on common stock, $2.1 million of stock repurchases and $265 thousand of stock surrendered. In addition, stockholders' equity was negatively impacted by the adoption of CECL in the first quarter of 2023, which resulted in an after-tax decrease to opening retained earnings of $1.1 million.

We paid regular quarterly dividends aggregating $0.74 per common share during the year ended December 31, 2023 and regular quarterly dividends aggregating $0.68 per common share and a special dividend of $0.10 per common share during the year ended December 31, 2022. This equates to a dividend payout ratio of 25.7% in 2023 and 23.1% in 2022. The Company expects to continue its current practice of paying quarterly cash dividends on common stock, subject to the Board of Directors’ discretion to modify or terminate this practice at any time and for any reason. Assuming continued payment of cash dividends during 2024 at the current quarterly dividend rate of $0.19 per share, our total dividend paid each quarter would be approximately $486 thousand based on the number of our outstanding shares at December 31, 2023. The dividends, if any, we may pay in the future may be limited as more fully discussed under “Business—How We Are Regulated—Limitations on Dividends and Stock Repurchases” contained in Item 1, Part I of this Form 10-K.

Stock Repurchase Plans. From time to time, our board of directors has authorized stock repurchase plans. In general, stock repurchase plans allow us to proactively manage our capital position and return excess capital to stockholders. Shares purchased under such plans may also provide us with shares of common stock necessary to satisfy obligations related to stock compensation awards. In January 2024, the Board of Directors approved a new stock repurchase program authorizing the Company to purchase up to $1.5 million of the Company’s issued and outstanding common stock over a period of 12 months expiring on January 26, 2025. The actual timing, number and value of shares repurchased under this stock repurchase program will depend on a number of factors, including constraints specified pursuant to any trading plan that may be adopted in accordance with Rule 10b5-1 of the SEC, prevailing stock prices, general business and market conditions, and alternative investment opportunities. See “Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities” contained in Item 5, Part II of this Form 10-K for additional information relating to stock repurchases.

Liquidity. Liquidity measures the ability to meet current and future cash flow needs as they become due. The liquidity of a financial institution reflects its ability to meet loan requests, to accommodate possible outflows in deposits and to take advantage of favorable movements in market interest rates. The ability of a financial institution to meet its current financial obligations is a function of its balance sheet structure, its ability to liquidate assets and its access to alternative sources of funds. The objective of our liquidity management is to manage cash flow and liquidity reserves so that they are adequate to fund our operations and to meet obligations and other commitments on a timely basis and at a reasonable cost. We seek to achieve this objective and ensure that funding needs are met by maintaining an appropriate level of liquid funds through asset/liability management, which includes managing the mix and time to maturity of financial assets and financial liabilities on our balance sheet. Our liquidity position is enhanced by our ability to raise additional funds as needed in the wholesale markets.

Asset liquidity is provided by liquid assets which are readily marketable or pledgeable or which will mature in the near future. Liquid assets generally include cash, interest-bearing deposits in banks, securities available for sale, maturities and cash flows from securities, sales of fixed rate residential mortgage loans in the secondary market and federal funds sold. Liability liquidity generally is provided by access to funding sources which include core deposits and advances from the FHLB and other borrowing relationships with third party financial institutions.

Our liquidity position is continuously monitored and adjustments are made to the balance between sources and uses of funds as deemed appropriate. Liquidity risk management is an important element in our asset/liability management process. We regularly model liquidity stress scenarios to assess potential liquidity outflows or funding problems resulting from economic disruptions, volatility in the financial markets, unexpected credit events or other significant occurrences deemed problematic by management. These scenarios are incorporated into our contingency funding plan, which provides the basis for the identification of our liquidity needs.

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As of December 31, 2023, we had $58.0 million in cash, cash equivalents and AFS securities, and $603 thousand in loans held-for-sale. At December 31, 2023, we had the ability to borrow up to $181.4 million in FHLB advances (in addition to FHLB advances outstanding at that date) and up to $18.3 million through the Federal Reserve's discount window, in each case subject to certain collateral requirements. We had $40.0 million in outstanding advances with the FHLB at December 31, 2023 and no outstanding borrowings with the Federal Reserve at December 31, 2023. We also had available $20.0 million of credit facilities with other financial institutions, with no balance outstanding at December 31, 2023. Subject to market conditions, we expect to utilize these borrowing facilities from time to time in the future to fund loan originations and deposit withdrawals, to satisfy other financial commitments, repay maturing debt and to take advantage of investment opportunities to the extent feasible. As of December 31, 2023, management is not aware of any events that are reasonably likely to have a material adverse effect on our liquidity, capital resources or operations. In addition, management is not aware of any regulatory recommendations regarding liquidity that would have a material adverse effect on us. For additional details, see “Note 10—Borrowings, FHLB Stock and Subordinated Notes” in the Notes to Consolidated Financial Statements contained in “Item 8. Financial Statements and Supplementary Data” of this Form 10-K.

In the ordinary course of business, we enter into contractual obligations and have additional commitments to make future payments. These include payments related to (i) short and long-term borrowings (Note 10—Borrowings, FHLB Stock and Subordinated Notes), (ii) time deposits with stated maturity dates (Note 9—Deposits) (iii) operating leases (Note 12—Leases) and (iv) commitments to extend credit and standby letters of credit (Note 18—Commitments and Contingencies).

We incur capital expenditures on an ongoing basis to expand and improve our product offerings, enhance and modernize our technology infrastructure, and to introduce new technology-based products to compete effectively in our markets. We evaluate capital expenditure projects based on a variety of factors, including expected strategic impacts (such as forecasted impact on revenue growth, productivity, expenses, service levels and customer retention) and our expected return on investment. The amount of capital investment is influenced by, among other things, current and projected demand for our services and products, cash flow generated by operating activities, cash required for other purposes and regulatory considerations. Based on current capital allocation objectives, there are no projects scheduled for capital investments in premises and equipment during the year ending December 31, 2024 that would materially impact liquidity.

Sound Financial Bancorp is a separate legal entity from Sound Community Bank and must provide for its own liquidity. In addition to its own operating expenses (many of which are paid to Sound Community Bank), Sound Financial Bancorp is responsible for paying for any stock repurchases, dividends declared to its stockholders, interest and principal on outstanding debt, and other general corporate expenses.

Sound Financial Bancorp is a holding company and does not conduct operations; its sources of liquidity are generally dividends up-streamed from Sound Community Bank, interest on investment securities, if any, and borrowings from outside sources. Banking regulations may limit the dividends that may be paid to us by Sound Community Bank. See, “Business — How We Are Regulated — Limitations on Dividends and Stock Repurchases” contained in Item 1, Part I of this Form 10-K. During the year ended December 31, 2020, the Company completed a private placement of $12.0 million in aggregate principal of subordinated notes resulting in net proceeds, after placement fees and offering expenses, of approximately $11.6 million. The Company contributed $5.5 million of the net proceeds from the sale of the subordinated notes to the Bank and retained the remaining net proceeds to be used for general corporate purposes. At December 31, 2023, Sound Financial Bancorp, on an unconsolidated basis, had $156 thousand in cash, noninterest-bearing deposits and liquid investments generally available for its cash needs.

See also the “Consolidated Statements of Cash Flows” included in “Item 8. Financial Statements and Supplementary Data” of this Form 10-K, for additional information regarding our sources and use of funds.

Regulatory Capital. Sound Community Bank is subject to minimum capital requirements imposed by regulations of the FDIC. Capital adequacy requirements are quantitative measures established by regulation that require Sound Community Bank to maintain minimum amounts and ratios of capital. Based on its capital levels at December 31, 2023, Sound Community Bank exceeded these requirements at that date. Consistent with our goals to operate a sound and profitable organization, our policy is for Sound Community Bank to maintain a "well-capitalized" status under the prompt corrective action capital categories of the FDIC.

Beginning January 2020, the Bank elected to use the CBLR framework. A bank that elects to use the CBLR framework as provided for in the Economic Growth, Regulatory Relief and Consumer Protection Act will generally be considered "well-capitalized" and to have met the risk-based and leverage capital requirements of the capital regulations if it has a leverage ratio greater than 9.0%. At December 31, 2023, the Bank’s CBLR was 10.99%, which exceeded the minimum requirements. For additional details, see “Note 16—Capital” in the Notes to Consolidated Financial Statements contained in "Item 8. Financial Statements and Supplementary Data" and "Item 1. Business—How We Are Regulated—Regulation of Sound Community Bank—Capital Rules" of this Form 10-K.

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For a bank holding company with less than $3.0 billion in assets, the capital guidelines apply on a bank-only basis and the Federal Reserve expects the holding company's subsidiary banks to be "well-capitalized" under the prompt corrective action regulations. If Sound Financial Bancorp were subject to regulatory guidelines for bank holding companies with $3.0 billion or more in assets, at December 31, 2023, Sound Financial Bancorp would have exceeded all regulatory capital requirements. The estimated CBLR calculated for Sound Financial Bancorp at December 31, 2023 was 9.78%.

Item 7.    MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This discussion and analysis reviews our consolidated financial statements and other relevant statistical data and is intended to enhance your understanding of our financial condition and results of operations. The information in this section has been derived from the Consolidated Financial Statements and footnotes thereto that appear in "Part II. Item 8. Financial Statements and Supplementary Data" of this Form 10-K. The information contained in this section should be read in conjunction with these Consolidated Financial Statements and footnotes and the business and financial information provided in this Form 10-K.

Overview

Our principal business consists of attracting retail and commercial deposits from the general public and investing those funds, along with borrowed funds, in loans secured by first and second mortgages on one-to-four family residences (including home equity loans and lines of credit), commercial and multifamily real estate, construction and land, and consumer and commercial business loans. Our commercial business loans include unsecured lines of credit and secured term loans and lines of credit secured by inventory, equipment and accounts receivable. We also offer a variety of secured and unsecured consumer loan products, including manufactured home loans, floating home loans, automobile loans, boat loans and recreational vehicle loans. As part of our business, we focus on residential mortgage loan originations, a portion of which we sell to Fannie Mae and other investors and the remainder of which we retain for our loan portfolio consistent with our asset/liability objectives. We sell loans which conform to the underwriting standards of Fannie Mae (“conforming”) in which we retain the servicing of the loan in order to maintain the direct customer relationship and to generate noninterest income. Residential loans which do not conform to the underwriting standards of Fannie Mae (“non-conforming”), are either held in our loan portfolio or sold with servicing released. We originate and retain a significant amount of commercial real estate loans, including those secured by owner-occupied and nonowner-occupied commercial real estate, multifamily properties and mobile home parks, and construction and land development loans.

We originated $125.6 million and $243.9 million of one-to-four family residential mortgage loans during the years ended December 31, 2022 and 2021, respectively. We had no purchases of one-to-four family residential mortgage loans during the year ended December 31, 2022 and $24.1 million of purchases during the year ended December 31, 2021. During those two years, we sold $20.3 million and $147.4 million, respectively, of one-to-four family residential mortgage loans.

Our strategic plan targets consumers, small- and medium-size businesses, and professionals in our market area for loans and deposits. In managing the size of, and concentrations within, our loan portfolio we typically focus on including a significant amount of commercial business and commercial and multifamily real estate loans. A significant portion of our commercial business and commercial and multifamily real estate loans have adjustable rates, higher yields and shorter terms, and higher credit risk than traditional residential fixed-rate mortgage loans. During 2022, however, due to a generally illiquid jumbo loan market, we retained a higher proportion of jumbo loans than we have historically, resulting in commercial business and commercial and multifamily real estate loans making up a lower percentage of our overall portfolio. Our commercial loan portfolio (commercial and multifamily real estate and commercial business loans) increased to $337.2 million at December 31, 2022 from $306.2 million at December 31, 2021, but decreased as a percentage of our total loan portfolio to 38.9% from 44.5% at December 31, 2022 and 2021, respectively. Our consumer loan portfolio, which includes manufactured and floating homes and other consumer loans, increased to $119.3 million or 13.8% of our loan portfolio at December 31, 2022, from $97.7 million or 14.2% of our loan portfolio at December 31, 2021.

Our operating revenues are derived principally from earnings on interest-earning assets, service charges and fees, and gains on the sale of loans. The increasing interest rate environment is expected to continue to put downward pressure on our net gain on sale of loans, as well as increase borrowing costs which may adversely affect our net interest income and net interest margin in 2023. Our primary sources of funds are deposits (both retail and brokered), FHLB advances, borrowings through the Federal Reserve, and payments received on loans and securities. We offer a variety of deposit accounts that provide a wide range of interest rates and terms, including savings, money market, NOW, interest-bearing and noninterest-bearing demand accounts, and certificates of deposit.

An offset to net interest income is the provision for loan losses, or the recapture of the provision for loan losses, that is required to establish the allowance for loan losses at a level that adequately provides for probable incurred losses in our loan portfolio. As our loan portfolio increases, or due to an increase for probable incurred losses in our loan portfolio, our provision for loan losses may increase, resulting in a decrease to net income. Improvements in loan risk ratings, increases in property values, or receipt of recoveries of amounts previously charged off may partially or fully offset any required increase to allowance for loan losses due to loan growth or an increase in probable incurred losses on loans. Our provision for loan losses was $1.2 million for the year ended December 31, 2022, compared to $425 thousand for the year ended December 31, 2021, primarily due to loan growth.

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Effective January 1, 2023, the Company adopted Accounting Standards Update (“ASU”) No. 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, also known as CECL. CECL replaces the existing incurred loss impairment methodology that recognizes credit losses when a probable loss has been incurred with new methodology where loss estimates are based upon lifetime expected credit losses. Adoption of this guidance is expected to result in an increase to our allowance for credit losses and reserve for unfunded commitments totaling between $1.0 million to $2.0 million in the aggregate. This estimate may change as the Company continues to improve and refine its processes and methodology. See “Note 2—Accounting Pronouncements Recently Issued or Adopted” in the Notes to Consolidated Financial Statements contained in “Part II. Item 8. Financial Statements and Supplementary Data” of this report on Form 10-K.

Our noninterest expenses consist primarily of salaries, employee benefits, incentive pay, expenses for occupancy, online and mobile services, marketing, professional fees, data processing, charitable contributions, FDIC deposit insurance premiums and regulatory expenses. Salaries and benefits consist primarily of the salaries paid to our employees, payroll taxes, directors' fees, retirement expenses, share-based compensation and other employee benefits. Occupancy expenses, which are the fixed and variable costs of buildings and equipment, consist primarily of lease payments, property taxes, depreciation charges, maintenance and the cost of utilities.

Recent Accounting Standards

For a discussion of recent accounting standards, see "Note 2—Accounting Pronouncements Recently Issued or Adopted" in the Notes to Consolidated Financial Statements contained in "Part II. Item 8. Financial Statements and Supplementary Data" of this report on Form 10-K.

Critical Accounting Estimates

We prepare our consolidated financial statements in accordance with GAAP. In doing so, we have to make estimates and assumptions. Our critical accounting estimates are those estimates that involve a significant level of uncertainty at the time the estimate was made, and changes in the estimate that are reasonably likely to occur from period to period, or use of different estimates that we reasonably could have used in the current period, would have a material impact on our financial condition or results of operations. Accordingly, actual results could differ materially from our estimates. We base our estimates on past experience and other assumptions that we believe are reasonable under the circumstances, and we evaluate these estimates on an ongoing basis. Facts and circumstances that could affect these judgments include, but are not limited to, changes in interest rates, changes in the performance of the economy and changes in the financial condition of borrowers. We have reviewed our critical accounting estimates with the audit committee of our Board of Directors.

See "Note 1—Organization and Significant Accounting Policies" in the Notes to Consolidated Financial Statements contained in "Part II. Item 8. Financial Statements and Supplementary Data" of this report on Form 10-K for a summary of significant accounting policies.

Allowance for Loan Loss. The allowance for loan losses is the amount estimated by management as necessary to cover losses inherent in the loan portfolio at the balance sheet date. The allowance is established through the provision for loan losses, which is charged to income. Determining the amount of the allowance for loan losses necessarily involves a high degree of subjectivity and requires us to make various assumptions and judgments about the collectability of our loan portfolio, including the creditworthiness of our borrowers and the value of the real estate and other assets serving as collateral for the repayment of many of our loans.

The allowance consists of specific, general and unallocated components. The general component of the allowance for loan losses covers non-impaired loans and is determined using a formula-based approach. The formula first incorporates either the historical loss rates of the Company or the historical loss rates of their peer group if minimal loss history exists. This historical loss rate factor is then adjusted for qualitative factors. Qualitative factors are used to estimate losses related to factors that are not captured in the historical loss rates and are based on management’s evaluation of available internal and external data and involve significant management judgement. Qualitative factors include changes in lending standards, changes in economic conditions, changes in the nature and volume of loans, changes in lending management, changes in delinquencies, changes in the loan review system, changes in the value of collateral, the existence of concentrations, and the impact of other external factors. Finally, the general component of the allowance for loan losses is adjusted for changes in the assigned grades of loans, which include the following: pass, watch, special mention, substandard, doubtful, and loss. As loans are downgraded from watch to the lower categories, they are assigned an additional factor to account for the increased credit risk. Loan grades involve significant management judgment. For such loans that are also classified as impaired, a specific component within the allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan are lower than the carrying value of that loan. An unallocated component is maintained to cover uncertainties that could affect

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management's estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.

Management reviews the level of the allowance at least quarterly and performs a sensitivity analysis on the significant assumptions utilized in estimating the allowance for loan losses for collectively evaluated loans. Utilizing a range of potential positive and negative changes to qualitative loss factors ranging from 5 to 20 basis points, the Bank's allowance for loan losses would change by a range of approximately $433 thousand to $1.7 million, respectively. This sensitivity analysis and related range of impact on the Bank's allowance for loan losses is a hypothetical analysis and is not intended to represent management’s judgments or assumptions of qualitative loss factors that were utilized at December 31, 2022.

To strengthen our loan review and classification process, we engage an independent consultant to review our classified loans and a significant sample of recently originated non-classified loans annually. We also enhanced our credit administration policies and procedures to improve our maintenance of updated financial data on commercial borrowers. While we believe the estimates and assumptions used in our determination of the adequacy of the allowance are reasonable, there can be no assurance that such estimates and assumptions will not be proven incorrect in the future, or that the future provisions will not exceed past provisions or that any increased provisions that may be required will not adversely impact our financial condition and results of operations. In addition, the determination of the amount of our allowance for loan losses is subject to review by bank regulators as part of the routine examination process, which may result in the adjustment of reserves based upon their judgment of information available to them at the time of their examination.

Other-Than-Temporary Impairment of Securities.  Management reviews investment securities on an ongoing basis for the presence of OTTI, taking into consideration current market conditions; fair value in relationship to cost; extent and nature of the change in fair value; issuer rating changes and trends; whether management intends to sell a security or if it is likely that we will be required to sell the security before recovery of the amortized cost basis of the investment, which may be upon maturity; and other factors. For debt securities, if management intends to sell the security or it is likely that we will be required to sell the security before recovering our cost basis, the entire impairment loss would be recognized in earnings as an OTTI loss. If management does not intend to sell the security and it is not more likely than not that we will be required to sell the security, but management does not expect to recover the entire amortized cost basis of the security, only the portion of the impairment loss representing credit losses would be recognized in earnings. The credit loss on a security is measured as the difference between the amortized cost basis and the present value of the cash flows expected to be collected. Projected cash flows are discounted by the original or current effective interest rate depending on the nature of the security being measured for potential OTTI. The remaining impairment related to all other factors, i.e., the difference between the present value of the cash flows expected to be collected and fair value, is recognized as a charge to other comprehensive income (loss). Impairment losses related to all other factors are presented as separate components within accumulated other comprehensive income (loss).

Mortgage Servicing Rights.  We record MSRs on loans sold to Fannie Mae with servicing retained as well as for acquired servicing rights. We stratify our capitalized MSRs based on the type, term and interest rates of the underlying loans. MSRs are carried at fair value. The value is determined through a discounted cash flow analysis, which uses interest rates, prepayment speeds and delinquency rate assumptions as inputs. All of these assumptions require a significant degree of management judgment. If our assumptions prove to be incorrect, the value of our MSRs could be negatively impacted. We use a third party to assist us in the preparation of the analysis of the market value each quarter.

Other Real Estate Owned.  OREO represents real estate that we have taken control of in partial or full satisfaction of significantly delinquent loans. At the time of foreclosure, OREO is recorded at the fair value less costs to sell, which becomes the property's new basis. Any write-downs based on the asset's fair value at the date of acquisition are charged to the allowance for loan losses. After foreclosure, management periodically performs valuations such that the real estate is carried at the lower of its new cost basis or fair value, net of estimated costs to sell. Subsequent valuation adjustments are recognized within net (loss) gain on OREO. Revenue and expenses from operations and subsequent adjustments to the carrying amount of the property are included in other noninterest expense in the consolidated statements of income. In some instances, we may make loans to facilitate the sales of OREO. Management reviews all sales for which it is the lending institution for compliance with sales treatment under provisions established by ASC Topic 360, "Accounting for Sales of Real Estate". Any gains related to sales of OREO are deferred until the buyer has a sufficient initial and continuing investment in the property.

Income Taxes.  Income taxes are reflected in our financial statements to show the tax effects of the operations and transactions reported in the financial statements and consist of taxes currently payable plus deferred taxes. ASC Topic 740, "Accounting for Income Taxes," requires the asset and liability approach for financial accounting and reporting for deferred income taxes. Deferred tax assets and liabilities result from differences between the financial statement carrying amounts and the tax bases of assets and liabilities. They are reflected at currently enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled and are determined using the assets and liability method of accounting. The deferred income provision represents the difference between net deferred tax asset/liability at the beginning

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and end of the reported period. In formulating our deferred tax asset, we are required to estimate our income and taxes in the jurisdiction in which we operate. This process involves estimating our actual current tax exposure for the reported period together with assessing temporary differences resulting from differing treatment of items, such as depreciation and the provision for loan losses, for tax and financial reporting purposes. Valuation allowances are established to reduce the net carrying amount of deferred tax assets if it is determined to be more likely than not all or some portion of the potential deferred tax asset will not be realized.

Business and Operating Strategies and Goals

Our goal is to deliver returns to stockholders by increasing higher-yielding assets (including consumer, commercial and multifamily real estate and commercial business loans), increasing lower-cost core deposit balances, managing expenses, managing problem assets and exploring expansion opportunities. We seek to achieve these results by focusing on the following objectives:

Focusing on Asset Quality.  We believe that strong asset quality is a key to our long-term financial success. We are focused on monitoring existing performing loans, resolving nonperforming assets and selling foreclosed assets. Nonperforming assets were $3.6 million, or 0.37% of total assets, at December 31, 2022 compared to $6.2 million or 0.68% of total assets, at December 31, 2021. We continually seek to reduce the level of nonperforming assets through collections, modifications and sales of OREO. We also take proactive steps to resolve our non-performing loans, including negotiating payment plans, forbearances, loan modifications and loan extensions on delinquent loans when such actions have been deemed appropriate. Our goal is to maintain or improve upon our level of nonperforming assets by managing all segments of our loan portfolio in order to proactively identify and mitigate risk.

Improving Earnings by Expanding Product Offerings. We intend to prudently maintain the percentage of our assets consisting of higher-yielding commercial and multifamily real estate and commercial business loans, which offer higher risk-adjusted returns, shorter maturities and more sensitivity to interest-rate fluctuations than one-to-four family mortgage loans, while maintaining our focus on residential lending. In addition, we continue to focus on consumer products, such as floating and manufactured home loans. With our long experience and expertise in residential lending we believe we can be effective in capturing mortgage banking opportunities and grow consumer deposits. We continue to develop correspondent relationships to sell nonconforming mortgage loans servicing released. We also intend to selectively add products to further diversify revenue sources and to capture more of each client's banking relationship by offering additional services. We continue to refine our products and services for additional business and automate services, such as automating consumer loan originations this past year, in an effort to improve customer service. We intend to further build relationships with medium and small businesses through new and improving existing service offerings, including remote deposit.

Emphasizing Lower Cost Core Deposits to Manage the Funding Costs of Our Loan Growth.  Our strategic focus is to emphasize total relationship banking with our clients to internally fund our loan growth. We also emphasize reducing wholesale funding sources, including FHLB advances, through the continued growth of core deposits. We believe that a continued focus on client relationships will help increase the level of core deposits and retail certificates of deposit from consumers and businesses in our market area. We intend to increase demand deposits by growing retail and business banking relationships. New technology and services are generally reviewed for business development and cost saving opportunities. We continue to experience growth in client use of our online and mobile banking services, which allow clients to conduct a full range of services on a real-time basis, including balance inquiries, transfers and electronic bill paying, while providing our clients greater flexibility and convenience in conducting their banking. In addition to our retail branches, we maintain state of the art technology-based products, such as business cash management, business remote deposit products, business and consumer mobile banking applications and consumer remote deposit products. Total deposits increased to $808.8 million at December 31, 2022, from $798.3 million at December 31, 2021. At December 31, 2022, core deposits, which we define as our non-time deposit accounts and time deposit accounts of less than $250 thousand, decreased $9.5 million to $745.7 million from $755.2 million at December 31, 2021. As a result of the decreased liquidity from core deposits, we increased our rates paid on certificates of deposit and borrowed against our FHLB lines of credit.

Maintaining Our Client Service Focus.  Exceptional service, local involvement (including volunteering and contributing to the communities where we do business) and timely decision-making are integral parts of our business strategy. Our employees understand the importance of delivering exemplary customer service and seeking opportunities to build relationships with our clients to enhance our market position and add profitable growth opportunities. We compete with other financial service providers by relying on the strength of our customer service and relationship banking approach. We believe that one of our strengths is that our employees are also significant stockholders through our ESOP and 401(k) plans. We also offer incentives that are designed to reward employees for achieving high-quality client relationship growth.

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Expanding Our Presence, Including Through Digital Channels and Streamlining Operations, Within Our Existing and Contiguous Market Areas and by Capturing Business Opportunities Resulting from Changes in the Competitive Environment.  We believe that opportunities currently exist within our market area to grow our franchise. We anticipate continued organic growth as the local economy and loan demand remains strong, through our marketing efforts and as a result of the opportunities created from the consolidation of financial institutions occurring in our market area. In addition, by delivering high-quality, client-focused products and services, we expect to attract additional borrowers and depositors and thus increase our market share and revenue generation. We continue to be disciplined as it pertains to future expansion, acquisitions and de novo branching focusing on the markets in Western Washington, which we know and understand.

Comparison of Financial Condition at December 31, 2022 and December 31, 2021

General.  Total assets increased by $56.7 million, or 6.2%, to $976.4 million at December 31, 2022, from $919.7 million at December 31, 2021. The increase was primarily a result of an increase in loans held-for-portfolio and investment securities, partially offset by lower balances in cash and cash equivalents and decreases in loans held-for-sale.

Cash and Securities.  Cash, cash equivalents, available-for-sale securities and held-to-maturity securities decreased by $121.8 million, or 63.4%, to $70.2 million at December 31, 2022 compared to the prior year. Cash and cash equivalents decreased $125.8 million, or 68.5%, to $57.8 million due to deploying cash earning a nominal yield into higher earning loans and investments. Available-for-sale securities, which consist of agency mortgage-backed securities and municipal bonds, increased $1.8 million, or 21.2%, to $10.2 million at December 31, 2022, primarily due to purchases of securities during the year outpacing calls of securities and regularly scheduled payments and maturities. Held-to-maturity securities totaled $2.2 million at December 31, 2022, compared to none at December 31, 2021, due to the purchase of $2.2 million in municipal bonds and agency mortgage-backed securities.

Loans.  Loans held-for-portfolio, net, increased $178.3 million, or 26.2%, to $858.4 million at December 31, 2022 from $680.1 million at December 31, 2021. Loans held-for-sale decreased to $0 at December 31, 2022 from $3.1 million at December 31, 2021 primarily due to a decline in mortgage originations, reflecting reduced refinance activity and the timing of originations.

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The following table reflects the changes in the loan mix, excluding premiums and deferred fees, of our portfolio at December 31, 2022, as compared to December 31, 2021 (dollars in thousands):

The largest dollar increases in the loan portfolio were in one-to-four family loans, which increased $67.0 million, or 32.3%, to $274.6 million, driven equally by jumbo and conforming residential mortgages, construction and land loans, which increased $53.8 million, or 85.2%, to $116.9 million, and commercial and multifamily real estate loans, which increased $35.2 million or 12.6%, to $313.4 million. We also saw increases in our floating homes and manufactured housing loan portfolios. The increase in loans held-for-portfolio primarily resulted from focused marketing campaigns, increased utilization of digital marketing tools and the addition of experienced lending staff. These increases were partially offset by a decrease in commercial business loans, which decreased $4.2 million or 15.0% to $23.8 million, primarily from the SBA loan forgiveness on PPP loans of $5.2 million. We had 2 PPP loans outstanding totaling $17 thousand as of December 31, 2022.

The loan portfolio remains well-diversified with commercial and multifamily real estate loans accounting for 36.1% of the portfolio, one-to-four family real estate loans, including home equity loans, accounting for approximately 33.9% of the portfolio and consumer loans, consisting of manufactured homes, floating homes, and other consumer loans, accounting for 13.8% of the total loan portfolio at December 31, 2022. Construction and land loans accounted for 13.5% of the portfolio and commercial business loans accounted for the remaining 2.7% of the portfolio at December 31, 2022.

Nonperforming Assets.  At December 31, 2022, our nonperforming assets totaled $3.6 million, or 0.37% of total assets, compared to $6.2 million, or 0.68% of total assets, at December 31, 2021.

The table below sets forth the amounts and categories of nonperforming assets in our loan portfolio at the dates indicated (dollars in thousands):