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

The following discussion is intended to assist in understanding the financial condition and results of operations of the Company for the year ended December 31, 2020. The information contained in this section should be read together with the December 31, 2020 audited Consolidated Financial Statements and Notes thereto included in Item 8. Financial Statements And Supplementary Data of this Form 10-K.

This section of this Form 10-K generally discusses 2020 and 2019 items and year-to-year comparisons between 2020 and 2019. Discussions of 2018 items and year-to-year comparisons between 2019 and 2018 that are not included in this Form 10-K can be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 of the Company’s Form 10-K for the fiscal year ended December 31, 2019.

COVID-19 Impacts

In response to the COVID-19 pandemic, and in an effort to mitigate the adverse impact on our employees, customers and the communities we serve, the Bank implemented various lending measures to address customer and community needs, including commercial, mortgage and consumer lending assistance. The Bank also implemented various retail-impacting measures for the safety and health of customers and employees. The following provides details of the Bank's special programs and policies.

Commercial Lending Assistance

The Bank made available the following initial short-term COVID Modifications to commercial borrowers affected by COVID-19:

•Interest only payments on term debt for up to 90 days;

•Temporary increases to line of credit commitments when supported by underlying assets, including changing the borrowing base formula or changing existing commitment restrictions to allow higher advance rates;

•Full payment deferrals for up to 90 days when an interest only period does not provide sufficient relief (contingent on credit administration approval);

•Loan re-amortization, especially in cases where significant prepayments of principal have occurred;

•Covenant waivers and resets;

•Processing new loan requests, such as a line of credit for working capital support; and

•Maturity extensions of up to 90 days for maturing lines of credit or term loans.

In the second quarter of 2020, the Bank implemented a special, streamlined initial 90-day interest only payment modification process for borrowers in certain industries as a result of the COVID-19 "stay at home" orders.

Once the initial 90-day relief option expired, the Bank extended similar relief options for a subsequent or second COVID Modification to certain commercial borrowers. The Bank maintained a preference for offering interest only payments on those secondary modifications. The Bank determined that in most instances, a request for a third payment deferral modification, where total modifications exceed 180 days, was considered a TDR status loan instead of a COVID Modification as the Bank incorporated policies consistent with regulatory guidance.

The Bank will work constructively with commercial borrowers to identify loan modifications that are based on the facts and circumstances of each borrower, and to protect the safety and soundness of the Bank.

All commercial COVID Modification loans were risk rated "Watch" or worse at initial modification date, except in certain cases where a borrower had performed well prior to the modification request and exhibited a strong financial position, or the loan had significant guarantor support, or if a more severe risk rating was determined appropriate given facts and circumstances of the borrower. Further requests for relief beyond the initial modification were reassessed for a more severe risk rating as part of the review process to grant further relief. For additional information regarding the Bank’s loan risk ratings see Note (4) Loans Receivable of the Notes to Consolidated Financial Statements included in Item 8. Financial Statements And Supplementary Data.

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Mortgage and Consumer Lending Assistance

In order to effectively manage or mitigate adverse impacts on mortgage and consumer borrowers affected by COVID-19, the Bank implemented the initial COVID Modification through a streamlined approval process to include 90-day payment deferrals when the borrower met the following criteria:

•The borrower's ability to pay had been negatively impacted by COVID-19;

•The loan was not over 30 days past due on the date of the request; and

•The loan was risk rated "Pass" prior to the request for payment deferral.

Mortgage and consumer loans that did not meet the criteria to receive streamlined approval qualifications were considered outside of the automatic deferral process and were evaluated on a case-by-case basis by the Bank's credit team. Certain consumer term loans with current balances over $100,000 and original terms over 96 months were reviewed on a case-by-case basis and did not qualify for the streamlined approval process. For consumer lines of credit, for borrowers that had sufficient available credit on their line, the borrower could draw on their line of credit to make payments in lieu of payment deferrals, and for borrowers that did not have sufficient available credit, the Bank offered a 90-day payment deferral. However, after the deferral period, these borrowers were billed for the deferred months of accrued interest and the Bank worked with those borrowers unable to pay all months of interest at that time. For credit card customers, a skip payment option was included in the borrowers' billing statements between April 1, 2020 and May 30, 2020.

Based on the depth and breadth of the COVID-19 pandemic, the Bank extended similar relief options for a subsequent or second COVID Modification to certain consumer borrowers. The Bank had a preference for offering interest only payments, or partial principal and interest payments, on these secondary COVID Modifications.

All initial COVID Modifications on mortgage and consumer loans remained risk rated "Pass" through the initial 90-day relief period. This risk rating was subject to change if the Bank received additional information within the 90-day relief period that the borrower did not intend to repay the loan, which resulted in a risk rating downgrade and the implementation of further collection efforts unless facts and circumstances of the borrower mitigated additional risk of nonperformance. Risk ratings were reviewed for a more severe classification for any borrower requesting a secondary COVID Modification.

Borrowers with COVID Modifications did not have negative data reported to the credit reporting agencies. Credit reporting was not turned off on these accounts, but contractual due dates were advanced in the core loan system with appropriate loan documentation to legally support the new due dates.

COVID-19 Modifications:

During the year ended December 31, 2020 and as a direct result of COVID-19 issues cited by the borrower and the Bank's lending assistance programs described above, the Bank made COVID Modifications on loans. These modifications were not classified as TDR status in accordance with the CARES Act and related regulatory guidance unless the payment deferment period exceeded 180-days.

The following table details the amortized cost and count by each loan class of modifications that were made during the year ended December 31, 2020, with amortized costs presented as of March 31, 2020, the date before the prolonged impacts of the COVID-19 pandemic:

Amortized Cost Count

(Dollars in thousands)

Commercial business:

Real estate construction and land development:

Commercial and multifamily 17,527 23

Total real estate construction and land development 24,529 52

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The following table presents COVID Modifications from the table above that were downgraded during the year ended December 31, 2020 that also had loan balances at December 31, 2020:

Pass (1) Watch Special Mention Substandard Total

(Dollars in thousands)

Commercial business:

Real estate construction and land development:

(1) Downgraded within the "Pass" rating scale of 1 to 5.

Of the $130.4 million of "Special Mention" or "Substandard" downgrades, $59.1 million was classified as nonaccrual or performing TDR and the rest were classified as potential problem loans.

The following table details the amortized cost and count of modifications by each loan class for any loan that was in active payment modification deferral status as of December 31, 2020, with balances and count at December 31, 2020:

Amortized Cost Count

(Dollars in thousands)

Commercial business:

Commercial and industrial $ 20,258 44

Real estate construction and land development:

One-to-four family residential 45 1

Commercial and multifamily 3,939 2

Total real estate construction and land development 3,984 3

Of the loans in active payment modification deferral status at December 31, 2020, $67.7 million, or 73.2%, were on their second or third loan deferral modification. Included in the total of active payment modification deferral status are loans classified as nonaccrual of $22.9 million and loans classified as performing TDR of $39.0 million. The risk classification of loans in active payment modification deferral status includes "Pass" rated of $10.8 million, "Watch" rated of $16.2 million, "Special Mention" rated of $3.0 million and "Substandard" rated of $62.5 million.

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COVID-19 Downgrades:

The Bank downgraded loans due to heightened risk as a direct result of COVID-19 issues cited by the borrower. All COVID-19 downgrades, including those with and without a modification, as of December 31, 2020 are as follows:

Pass (1) Watch Special Mention Substandard Total

(Dollars in thousands)

Commercial business:

Real estate construction and land development:

One-to-four family residential — — — — — — — — — —

(1) Downgraded within the "Pass" rating scale of 1 to 5.

Loans in the table above which were downgraded to Special Mention or worse are classified as potential problem loans, except for loans totaling $21.6 million and $37.5 million that were classified as nonaccrual and performing TDR, respectively, at December 31, 2020.

SBA Paycheck Protection Program

Beginning April 6, 2020, the Bank began to offer SBA PPP loans to its existing and new customers as a results of provisions in the CARES Act for customers directly impacted by the COVID-19 pandemic. SBA PPP loans are designed to provide a direct incentive for small businesses to keep their workers on the payroll. The CARES Act and its subsequent amendments allocated $669.0 billion to the program. Utilizing our internal technology solutions team, the Bank was able to develop an automated platform to control and manage processing for SBA PPP loans and immediately began originations under this program. The Bank accepted applications for SBA PPP loans, including loans to independent contractors, sole proprietors and partnerships as allowed under the guidance from the U.S. Treasury and SBA that was issued April 14, 2020. The Bank funded 4,642 loans totaling $897.4 million through the program's conclusion on August 8, 2020. The average loan balance for funded loans was $193,000. Of the funded loans, approximately 21% of both the number of loans funded and amount originated were to customers with no prior banking relationship to the Bank.

The Bank earns 1% interest on these loans as well as a fee from the SBA to cover processing costs, which is amortized over the life of the loan. The balance of unamortized net deferred fees on SBA PPP loans was $15.4 million at December 31, 2020.

The CA Act renews and extends the PPP until March 31, 2021 by authorizing an additional $284.5 billion for the program. As a result, the Bank began originating SBA PPP loans again starting in January 2021.

Additionally, the Federal Reserve established the PPPLF under Section 13(3) of the Federal Reserve Act to bolster the effectiveness of the SBA's PPP. Under the PPPLF, the Bank may pledge its SBA PPP loans as collateral at face value to obtain Federal Reserve Bank non-recourse loans. The maturity date of any PPPLF advance (the “Maturity Date”) will be the maturity date of the SBA PPP loan pledged to secure the PPPLF advance. The Maturity Date of any PPPLF advance will be accelerated on and to the extent of (i) the date of any loan forgiveness reimbursement by the SBA for any SBA PPP loan securing the PPPLF advance; or (ii) the date of purchase by the SBA from the Bank of any SBA PPP loan securing the PPPLF loan advance to realize on the SBA’s guarantee of the SBA PPP loan. PPPLF advances may be obtained until December 31, 2020. Although the Bank was approved to utilize the PPPLF, the Bank chose not to participate in PPPLF during the year ended December 31, 2020. See Note (25) Subsequent Events of the Notes to Consolidated Financial Statements included in Item 8. Financial Statements And Supplementary Data for a discussion about the renewal of this facility subsequent to December 31, 2020.

The Bank began processing loan forgiveness applications, as allowed under the SBA's PPP, during the fourth quarter of 2020. As of December 31, 2020, the Bank received principal and interest forgiveness payment of $159.2 million from the SBA.

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SBA Relief

Heritage is an active SBA lender in the Pacific Northwest and had SBA loans totaling $62.0 million and $64.1 million at December 31, 2020 and December 31, 2019, respectively. During the year ended December 31, 2020, Heritage participated in the SBA's Debt Relief Program under the CARES Act. The CARES Act appropriated $17.0 billion to subsidize small business loans. Under this program, the SBA paid principal and interest for existing current SBA loans for a period of six months, commencing with payments due after March 27, 2020 as well as new SBA 7(a), 504, and microloans disbursed prior to September 27, 2020.

Under this program, the borrowers did not have to reimburse the SBA or the Bank for these payments. If a borrower had already requested a payment deferral, and the deferral was granted, the six month period began after the deferment period. There was no limitation to the monthly principal and interest amount that the SBA would pay on behalf of the borrower. The borrower could also make other principal-only payments during the six month period.

The Bank did not consider any loans for which the SBA was making the principal and interest payment as a COVID Modification loan as only the source of payment was changed and not the payment terms of the SBA loan.

Retail Policy Changes

The COVID-19 pandemic caused significant disruptions to the Bank's operations and resulted in the implementation by the Bank of various social distancing measures to address customer and community needs.

•Branch Lobby Closures. To ensure the safety of our customers and employees, branch lobbies have been closed since March 2020 with most services processed through the drive-up or by appointment, except three branches located within Island County, which opened temporarily during the summer and fall as was allowed under Washington State's Phased Approach: Reopening Business and Modifying Physical Distancing Measures.

•Early Withdrawal Penalty Waivers. For customers that may need access to funds in their certificate of deposits to assist with living expenses during the COVID-19 pandemic, the Bank assisted these customers by waiving early withdrawal penalties for withdrawals up to $25,000.

•Overdraft & Fee Reversals. Overdraft and fee reversals were waived on a case-by-case basis. The Bank was cautious when paying overdrafts beyond the customer's total deposit relationship, overdraft protection options or their overdraft coverage limits.

Employee Changes

Heritage has committed to keeping its employees safe during this COVID-19 pandemic. As a result, many policy changes have been implemented including the following measures:

•Heritage follows the guidelines recommended by the Centers for Disease Control and/or local officials, such as social distancing and maintaining six feet of separation between employees.

•Heritage has provided additional cleaning and disinfecting solutions to each location.

•A significant number of back-office employees are working remotely.

•Essential business travel is limited to those situations where business cannot reasonably be conducted without face-to-face interaction or visits to specific locations.

•Certain front-line employees were given additional hourly pay.

•Heritage offered up to 80 hours for full time employees of COVID-19 related absences, to use in lieu of sick or vacation time, for the employee's own illness, to care for an ill family member, due to a required self-isolation/quarantine or school/day care closures.

Heritage continues to monitor the situation and makes additional accommodations as necessary.

Critical Accounting Policies

The Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States of America. Companies may apply certain critical accounting policies requiring management to make subjective or complex judgments, often as a result of the need to estimate the effect of matters that are inherently uncertain.

The Company considers its most critical accounting estimates to be as follows:

ACL on Investment Securities Available for Sale

Management evaluates the need for an ACL on investment securities available for sale on at least a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. For investment securities available for sale in an unrealized loss position, the Company first assesses whether it intends to sell or it is more likely than not that it will be required to sell the security before the recovery of its amortized cost basis. If either of the criteria regarding intent or requirement to sell is met, the security’s amortized cost basis is written down to fair value through a provision for credit loss against income. For investment securities available for sale that do not meet the aforementioned criteria, the Company evaluates whether the decline in fair value has resulted from credit losses or other factors. In making this assessment, management considers the extent to which fair value is less than amortized cost, any changes to the rating of the security by a rating agency and adverse conditions specifically related to the security, among other factors. The credit loss is defined as the difference between the present value of the cash flows expected to be collected and the amortized cost basis. If the present value of cash flows expected to be collected is less than the amortized cost basis, a credit loss exists and an ACL on investment securities available for sale is recorded for the credit loss, limited by the amount that the fair value is less than the amortized cost basis. Any

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unrealized decline in fair value that has not been recorded through an ACL on investment securities available for sale is recognized in other comprehensive income.

For additional information regarding the ACL on investment securities available for sale, see Note (3) Investment Securities of the Notes to Consolidated Financial Statements included in Item 8. Financial Statements And Supplementary Data.

ACL on Loans

Management utilizes a historic loss, open pool CECL methodology to calculate the ACL on loans. Under this methodology, nonaccrual loans are evaluated for credit losses on an individual basis and the remainder of the portfolio is disaggregated into similar segments of loans which are collectively evaluated for ACL on loans at the segment level. The determination of the evaluation method applied to each loan in the portfolio is a subjective management estimate based on the facts and circumstances surrounding each loan.

The allowance for individually evaluated loans is calculated using either the collateral value method, which considers the likely source of repayment as the value of the collateral, less estimated costs to sell if applicable, or the net present value method, which considers the contractual principal and interest terms and estimated cash flows available from the borrower to satisfy the debt. The determination of which method to apply and the application of either method, including evaluating the contractual principal and interest terms and estimated cash flows for the net present value method or the valuation of the collateral, less an estimate of selling costs, are subjective management estimates.

For each loan segment collectively evaluated for an ACL on loans, a baseline allowance and a macroeconomic allowance is calculated in the model. For the baseline allowance, a baseline loss rate is calculated at the segment level using the Bank's historical loss rates which are calculated using the Bank's average quarterly historical loss information. The calculated loss rates are applied to each loan's estimated cash flows over the life of the loan under the remaining life method to determine the loss estimate for each loan. Estimated cash flows consider the principal and interest in accordance with the contractual term of the loan and estimated prepayments. Prepayments are a subjective management estimate established for each segment based on rolling historical averages for the segments, which management believes is an accurate representation of future prepayment activity. Management reviews the adequacy of the prepayment period assumption on a quarterly basis.

The Company utilizes a macroeconomic sensitive model to adjust each segment's baseline loss rate over a reasonable and supportable forecast period and then reverts to the Bank's historical baseline loss rates for the remainder of the expected life of the loan segment. The macroeconomic sensitive model is developed for each segment given the current and forecasted economic conditions and a macroeconomic multiplier is calculated for each forecasted period considering the forecasted losses as compared to the long-term average actual losses of the dataset. The impact of those macroeconomic factors to each segment, both positive or negative, using the reasonable and supportable period, are considered the macroeconomic allowance. After the reasonable and supportable period, forecasted loss rates revert to historical baseline loss levels over the predetermined reversion period on a straight-lined basis. The reasonable and supportable forecast period, the reversion period, and the period used to calculate the Bank's average quarterly historical loss information at the segment level are based on subjective management estimates.

Management also considers other qualitative risk factors to adjust the estimated ACL on loans calculated by the above-mentioned model for internal or external factors outside of those considered in its historical losses or macroeconomic forecast. The qualitative adjustments are also based on subjective management estimates.

In general, management's estimate of the ACL on loans uses relevant available information, from internal and external sources, relating to past events, current conditions, and reasonable and supportable forecasts. The evaluation of ACL on loans is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available. While management utilizes its best judgment and information available to recognize credit losses on loans, future additions to the allowance may be necessary based on further declines in local and national economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Bank’s ACL on loans. Such agencies may require the Bank to make adjustments to the allowance based on their judgments about information available to them at the time of their examinations. The Company believes the ACL on loans is appropriate at December 31, 2020 given all of the above considerations.

For additional information regarding the ACL on loans, its relation to the provision for credit losses, its risk related to asset quality and lending activity, see “Provision for credit losses overview” and “Analysis of allowance for credit losses on loans” below, Item 1A. Risk Factors—Our ACL on loans may prove to be insufficient to absorb losses in our loan portfolio as well as Note (5) Allowance for Credit Losses on Loans of the Notes to Consolidated Financial Statements included in Item 8. Financial Statements And Supplementary Data.

ACL on Unfunded Commitments

The Bank estimates expected credit losses on unfunded, off-balance sheet commitments over the contractual period in which the Bank is exposed to credit risk from a contractual obligation to extend credit, unless the obligation is unconditionally cancellable by the Bank. The Bank has determined that no allowance is necessary for the off-balance sheet portion of the credit card portfolio as it has the ability to unconditionally cancel the available lines of credit.

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The allowance methodology for unfunded commitments is similar to the ACL on loans, but additionally includes considerations of the current utilization of the commitment and an estimate of the future utilization as determined appropriate by historical commitment utilization and the Bank's estimates of future utilization given current economic forecasts.

For additional information regarding the ACL on unfunded commitments, see Note (15) Commitments and Contingencies of the Notes to Consolidated Financial Statements included in Item 8. Financial Statements And Supplementary Data.

Business Combinations

The Company applies the acquisition method of accounting for business combinations. Under the acquisition method, the acquiring entity in a business combination recognizes all of the identifiable assets acquired and liabilities assumed at their acquisition date fair values. Management utilizes prevailing valuation techniques appropriate for the asset or liability being measured in determining these fair values. Any excess of the purchase price over amounts allocated to assets acquired, including identifiable intangible assets, and liabilities assumed is recorded as goodwill. Where amounts allocated to assets acquired and liabilities assumed is greater than the purchase price, a bargain purchase gain is recognized. Acquisition-related costs are expensed as incurred unless they are directly attributable to the issuance of the Company's common stock in a business combination and the Company chooses to record these acquisition-related costs through stockholders' equity.

There were no business combinations during the years ended December 31, 2020 and 2019. For additional information see Note (2) Business Combination of the Notes to Consolidated Financial Statements included in Item 8. Financial Statements And Supplementary Data for information regarding the business combinations completed during the year ended December 31, 2018.

Goodwill

The Company’s goodwill is assigned to Heritage Bank and is evaluated for impairment at the Heritage Bank level (reporting unit). Goodwill is reviewed for impairment annually and between annual tests if an event occurs or circumstances change that might indicate the Company’s recorded value is more than its implied value. Such indicators may include, among others: a significant adverse change in legal factors or in the general business climate; significant decline in the Company’s stock price and market capitalization; unanticipated competition; and an adverse action or assessment by a regulator. Any adverse changes in these factors could have a significant impact on the recoverability of goodwill and could have a material impact on the Consolidated Financial Statements.

The Company typically performed a quantitative goodwill impairment test as of December 31st using the Company's market capitalization as an indicator of fair value. During the second quarter of 2020, the Company determined a triggering event occurred due to the deteriorating financial market and economic conditions as a result of the COVID-19 pandemic and consequently engaged a third-party valuation specialist to perform a detailed quantitative assessment of goodwill as of May 31, 2020. Management estimated the fair value of the reporting unit by weighting results from the market approach and the income approach. Significant assumptions inherent in the valuation methodologies for goodwill were employed and included, but were not limited to, prospective financial information, growth rates, terminal value, discount rates, and comparable multiples from publicly traded companies in our industry. Based on this quantitative test, management determined that the fair value of the reporting unit more likely than not exceeded the carrying value.

The Company performed its annual goodwill impairment test during the fourth quarter of 2020 and determined, based on a qualitative assessment utilizing the Company's market capitalization, that it is more likely than not that the fair value of the reporting unit exceeded the carrying value, such that the Company's goodwill was not considered impaired for the year ended December 31, 2020. Changes in the economic environment, operations of the reporting unit or other adverse events, including as a result of COVID-19, could result in future impairment charges which could have a material adverse impact on the Company’s operating results.

For additional information regarding goodwill, see Note (8) Goodwill and Other Intangible Assets of the Notes to Consolidated Financial Statements included in Item 8. Financial Statements And Supplementary Data.

Financial Overview

Heritage Financial Corporation is a bank holding company which primarily engages in the business activities of our wholly-owned financial institution subsidiary, Heritage Bank. We provide financial services to our local communities with an ongoing strategic focus on our commercial banking relationships, market expansion and asset quality.

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Consolidated Financial Condition Overview

The table below provides a comparison of the changes in the Company's financial condition from December 31, 2019 to December 31, 2020:

(Dollars in thousands)

Assets

Liabilities

Stockholders' equity

Total assets increased $1.06 billion, or 19.1%, to $6.62 billion as of December 31, 2020 compared to $5.55 billion as of December 31, 2019 due primarily to an increase in loans receivable, which is discussed in more detail below in the "Lending Activities Overview" section, and in cash and cash equivalents due primarily to an increase in total deposits, offset partially by a decrease in investment securities available for sale, which is discussed in more detail below in the "Investment Activities Overview" section. Prepaid expenses and other assets increased $29.2 million, or 17.8%, to $193.3 million at December 31, 2020 from $164.1 million at December 31, 2019 primarily as a result of an increase in the fair value of interest rate swap contracts of $17.4 million and a new investment in a low income housing tax credit partnership of $10.2 million, both of which had a nearly corresponding increase in accrued expenses and other liabilities. Accrued expenses and other liabilities increased $20.1 million, or 16.7%, to $140.3 million at December 31, 2020 compared to $120.2 million as of December 31, 2019 due to the changes described above for prepaid expenses and other assets, partially offset by a decrease related to capital contributions to low income housing tax credit partnerships of $7.1 million.

Total deposits increased $1.02 billion, or 22.2%, to $5.60 billion at December 31, 2020 from $4.58 billion at December 31, 2019 due primarily to increases in noninterest bearing demand deposits of $534.0 million, or 36.9%, to $1.98 billion, money market accounts of $209.3 million, or 27.8%, to $963.0 million, and interest bearing demand deposits of $367.3 million, or 27.2%, to $1.72 billion, offset partially by a decrease in certificate of deposit accounts of $125.0 million, or 23.8%, to $399.5 million. The increase in total deposits was due primarily to proceeds from SBA PPP loans deposited directly into customer deposit accounts and an increase in customer deposits due to changes in customer spending habits due to the COVID-19 pandemic and an increase in new deposit accounts, offset partially by a decrease in a public depositor relationship of $95.7 million. Non-maturity deposits as a percentage of total deposits increased to 92.9% as of December 31, 2020 from 88.6% at December 31, 2019.

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Investment Activities Overview

Our investment policy is established by the Board of Directors and monitored by the Risk Committee of the Board of Directors. It is designed primarily to provide and maintain liquidity, generate a favorable return on investments without incurring undue interest rate and credit risk, and complements the Bank's lending activities. The policy dictates the criteria for classifying securities as either available for sale or held to maturity. The policy permits investment in various types of liquid assets permissible under applicable regulations, which include U.S. Treasury obligations, U.S. government agency obligations, some certificates of deposit of insured banks, mortgage-backed and mortgage-related securities, corporate notes, municipal bonds, and federal funds. Investment in non-investment grade bonds and stripped mortgage-backed securities is not permitted under the policy.

Investment securities available for sale decreased $150.1 million, or 15.8%, to $802.2 million at December 31, 2020 from $952.3 million at December 31, 2019. The decrease was due primarily to maturities, calls and payments of investment securities of $264.2 million and sales of investment securities of $55.0 million, offset partially by purchases of investment securities of $152.6 million. In addition, we recorded net unrealized gains of $18.8 million due to a decrease in market interest rates during the year ended December 31, 2020 that positively impacted the fair value of our bond portfolio. The following table provides information regarding our investment securities available for sale at the dates indicated:

(Dollars in thousands)

The following table provides information regarding our investment securities available for sale, by contractual maturity, at December 31, 2020:

(Dollars in thousands)

(1) Taxable equivalent weighted average yield.

Lending Activities Overview

The Bank is a full-service commercial bank, which originates a wide variety of loans with a focus on commercial business loans. Loans receivable increased $700.8 million, or 18.6%, to $4.47 billion at December 31, 2020 from $3.77 billion at December 31, 2019 due primarily to SBA PPP loans of $715.1 million outstanding at December 31, 2020, following principal and interest forgiveness payments from the SBA of $159.2 million during the year ended December 31, 2020. Loans receivable also increased due to increases in non-owner occupied CRE loans of $121.5 million, owner-occupied CRE loans of $51.5 million and real estate construction and land development loans of $31.1 million, offset partially by decreases in commercial and industrial

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loans of $119.1 million and consumer loans of $90.4 million. The decrease in commercial and industrial loans was due primarily to a decrease in the utilization rate of commercial and industrial lines of credit to 24.9% at December 31, 2020 from 34.5% at December 31, 2019. The decrease in consumer loans was primarily due to the cessation of indirect auto loan originations in March 2020.

The following table provides information about our loan portfolio by type of loan at the dates indicated:

December 31,

(Dollars in thousands)

Commercial business:

Real estate construction and land development:

(1) Balances do not include unfunded loan commitments.

(2) Percent of loans receivable.

(3) Excludes loans held for sale of $4.9 million, $5.5 million, $1.6 million, $2.3 million, and $11.7 million as of December 31, 2020, 2019, 2018, 2017 and 2016, respectively.

Included in the amortized cost of loans are net discounts on loans purchased in mergers and acquisitions. Upon CECL Adoption, the Bank increased the net discount for PCD loans by $1.6 million related to the PCI to PCD transition. The remaining total net discount for purchased loans, including PCD loans and non-PCD loans, was $6.6 million at December 31, 2020 compared to $8.4 million at December 31, 2019.

The following table presents the amortized cost of the loan portfolio by segment and the aggregate amount of fixed rate and variable or adjustable rate loans in our portfolio at December 31, 2020 for the following categories of contractual maturities:

Maturing

One Year or Less Over One to Five Years Over Five Years Total

(In thousands)

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(1) Includes certain commercial loans in which the Bank entered into non-hedge interest rate swap contracts with the borrower and a third-party. Under these derivative contract arrangements, the Bank effectively earns a variable rate of interest based on the one-month LIBOR plus a margin, except for interest rate swap contracts on construction loans that earn fixed rates until the end of the construction period and the variable rate swap becomes effective. At December 31, 2020, the Bank had 84 separate interest rate swap contracts with borrowers with a total notional value (which approximates amortized cost) of $308.1 million compared to 60 separate interest rate swap contracts with borrowers with notional value of $221.4 million at December 31, 2019. All but nine interest rate swap contracts with borrowers with a total notional value of $31.1 million at December 31, 2020 have a maturity of over five years.

Nonperforming Assets and Credit Quality Metrics

The following table provides information about our nonaccrual loans, other real estate owned and performing TDR loans for the dates indicated:

December 31,

(Dollars in thousands)

Nonaccrual loans:

Performing TDR loans:

Accruing loans past due 90 days or more $ — $ — $ — $ — $ —

(1) At December 31, 2020, 2019, 2018, 2017 and 2016, $43.1 million, $26.3 million, $6.9 million, $5.2 million and $6.9 million of nonaccrual loans were considered nonperforming TDR loans, respectively, with a related ACL on loans of $6.3 million, $218,000, $658,000, $379,000, and $437,000, respectively.

(2) See the "Reconciliations of Non-GAAP Measures" section below.

(3) Potential problem loans are risk rated "Special Mention" or worse that are not classified as a performing TDR or nonaccrual loan and are not individually evaluated for credit loss, but which management is closely monitoring because the financial information of the borrower causes concern as to their ability to meet their loan repayment terms.

Nonaccrual Loans. Nonaccrual loans increased $13.6 million to $58.1 million, or 1.30% of loans receivable at December 31, 2020, from $44.5 million, or 1.18% of loans receivable at December 31, 2019. The increase was due primarily to the addition of $23.4 million of loans that were previously COVID Modifications and which exhibited a continued decline in credit

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quality, warranting transfer to nonaccrual status. Within these additions were six commercial business lending relationships totaling $23.2 million, including loans in industries heavily impacted by the COVID-19 pandemic such as hospitality, entertainment and leisure facilities. The Bank is actively working with the borrowers to secure a positive resolution. These additions to nonaccrual loans were offset partially by principal payments which included full payoffs of $11.0 million, including a significant agricultural lending relationship of $6.8 million.

The ratio of ACL on loans to nonperforming loans increased to 120.82% at December 31, 2020 compared to 81.24% at December 31, 2019 due primarily to an increase in the ACL on loans.

The following table reflects the changes in nonaccrual loans during the periods indicated:

Year Ended December 31,

(In thousands)

Nonaccrual loans

Addition of previously classified pass graded loans 19,430 4,620

Addition of previously classified potential problem loans 8,993 23,032

Addition of previously classified performing TDR loans 4,601 11,734

Transfer to accruing status (281) —

Transfer to OREO (270) —

At December 31, 2020, nonaccrual loans of $27.3 million had a related ACL on loans of $6.7 million and nonaccrual loans of $30.8 million had no related ACL on loans. At December 31, 2019 nonaccrual loans of $4.4 million had a related ACL of $763,000 and nonaccrual loans of $40.1 million had no ACL.

Nonperforming Assets. Nonperforming assets consist of nonaccrual loans and other real estate owned. Nonperforming assets increased $12.7 million to $58.1 million, or 0.88% of total assets, at December 31, 2020 from $45.4 million, or 0.82% of total assets, at December 31, 2019 due primarily to the increase in nonaccrual loans discussed above partially offset by a decrease in other real estate owned resulting from the disposition of the two remaining properties during the year ended December 31, 2020.

Troubled Debt Restructured Loans. Performing TDR loans are TDRs on accrual status which are collectively evaluated for ACL based on criteria outlined in our accounting policies. Performing TDR loans are not considered nonperforming assets as they continue to accrue interest despite the restructured status. Performing TDR loans increased $38.4 million, or 265.4%, to $52.9 million at December 31, 2020 from $14.5 million at December 31, 2019. The increase was due to the addition of $39.0 million of loans with COVID Modifications that were subsequently modified to extend beyond the COVID Modification's 180-days payment deferment period in accordance with Bank policy for COVID Modifications. The increase in performing TDR loans was offset partially by one predominately commercial and industrial loan relationship totaling $4.2 million which transferred to nonaccrual status as the loan continued to show credit deterioration. Included in the net principal payments of performing TDR loans was loans paid in full of $3.7 million.

The following table reflects the changes in performing TDR loans during the periods indicated:

Year Ended December 31,

(In thousands)

Performing TDR loans

Addition of previously classified pass graded loans 6,967 6,846

Addition of previously classified potential problem loans 40,860 9,424

Loans added formerly nonaccrual loans 281 —

Transfers of loans to nonaccrual status (4,601) (11,734)

Charge-offs — (220)

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The related ACL on loans for performing TDR loans was $1.3 million as of both December 31, 2020 and December 31, 2019.

Potential Problem Loans. Potential problem loans are loans risk rated special mention or worse that are not classified as a TDR or nonaccrual loan and are not individually evaluated for credit loss, but which management is closely monitoring because the financial information of the borrower causes concern as to their ability to meet their loan repayment terms. Potential problem loans increased $94.6 million, or 107.7%, to $182.3 million at December 31, 2020 from $87.8 million at December 31, 2019. The increase was primarily attributed to risk downgrades related to borrowers experiencing COVID-19 related issues. Included in the balance of potential problem loans at December 31, 2020 are COVID Modifications of $86.8 million and loans that were downgraded due to COVID-19 issues with no loan modification of $52.1 million. At December 31, 2020, potential problem loans totaling $149.9 million and $32.4 million were rated special mention and substandard, respectively. The increase in potential problem loans for the year ended December 31, 2020 was offset partially by net principal payments of $37.8 million, including payments in full of $23.8 million, and transfers of loans to nonaccrual and TDR status of $49.9 million due primarily to loans that showed additional credit deterioration due to the COVID-19 pandemic or which were modified beyond the Bank's 180-day deferral policy and transferred to TDR status.

The following table reflects the changes in potential problem loans during the periods indicated:

Year Ended December 31,

(In thousands)

Potential problem loans

Addition of previously classified pass graded loans 194,589 69,775

Upgrades to pass graded loan status (12,335) (17,183)

Transfers of loans to nonaccrual and TDR status (49,853) (32,456)

Charge-offs — (510)

Analysis of Allowance for Credit Losses on Loans

Effective January 1, 2020, the Bank adopted ASU 2016-13. The adoption replaced the ALL with the ACL on loans on the Consolidated Statements of Financial Condition and replaced the related provision for loan losses with the provision for credit losses on loans on the Consolidated Statements of Income.

Management adopted a historic loss, open pool CECL methodology to calculate the ACL on loans. The same methodology is applied to all loans consistent with the guidance of the accounting standard which does not require undue complexity. Under this allowance approach, the Company has identified segments of loans with similar risk characteristics that align with its identified loan classes. Nonaccrual loans are not considered to have similar risk characteristics as other loans; therefore, they are evaluated for credit loss on an individual basis. The allowance for individually evaluated loans is calculated using either the collateral value method, which considers the likely source of repayment as the value of the collateral, less estimated costs to sell if applicable, or the net present value method, which considers the contractual principal and interest terms and estimated cash flows available from the borrower to satisfy the debt.

For each loan segment collectively measured, baseline loss rates are separately calculated using the Bank's average quarterly historical loss information. The baseline loss rates are applied to each loan's estimated cash flows over the life of the loan under the remaining life method, including prepayment estimates, to determine the baseline loss estimate for each loan. The CECL methodology also includes consideration of the forecasted direction of the economic and business environment and its likely impact to the estimated allowance as compared to the historical losses over the reasonable and supportable time frame. The impact of those macroeconomic factors to each segment, positive or negative, using the reasonable and supportable period, are added to the calculated baseline loss rate and are used to establish a macroeconomic allowance. After the reasonable and supportable period, the estimated credit losses revert back to historical baseline loss levels under a reversion period on a straight-lined, input reversion basis. Management can also consider other qualitative factors to adjust the ACL on loans if internal or external conditions suggest changes to the modeled ACL on loans are appropriate.

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The following table provides information regarding changes in our ACL on loans and the ACL at and for the years indicated:

At or For the Years Ended December 31,

(Dollars in thousands)

Impact of CECL Adoption 1,822 — — — —

Charge-offs:

Residential real estate — (60) (45) (30) —

Real estate construction and land development (417) (133) — (556) (154)

Recoveries:

Residential real estate 3 — — 2 2

(1) See "Reconciliations of Non-GAAP Measures" section below.

(2) Excludes loans held for sale.

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The following table shows the ACL on loans by segment at the indicated dates:

December 31,

(Dollars in thousands)

(1) Represents the percent of loans receivable by loan category to loans receivable.

The ACL on loans increased $34.0 million, or 94.0%, to $70.2 million at December 31, 2020 from $36.2 million at December 31, 2019, and increased $32.2 million, or 84.7%, from the adjusted beginning balance of $38.0 million. The increase in the ACL on loans was primarily the result of the provision for credit losses on loans of $35.4 million during the year ended December 31, 2020 due primarily to forecasted credit deterioration reflecting economic conditions as a result of the COVID-19 pandemic.

The macroeconomic forecast used in the CECL model as of January 1, 2020 predicted continued economic expansion with steady GDP growth of 1.8% and low unemployment rate averages of 3.5% in 2020, among other factors. The onset of the COVID-19 pandemic resulted in the identification of an economic recession during the second quarter of 2020 as evidenced by certain economic forecasts signaling prolonged, profound, and pervasive contraction in economic activities due to the COVID-19 pandemic. The GDP contracted 3.4% during the year ended December 31, 2020 and unemployment rates averaged 8.1%. The macroeconomic forecast used in the CECL model as of December 31, 2020 reflected a slow recovery from the COVID-19 recession modeled to last through the end of 2021, including an anticipated GDP growth of 4.3% for 2021 and GDP growth slightly above 2.0% thereafter. The unemployment rate is anticipated to remain above 6.0% during 2021 and steadily decrease to a stabilized 4.0% in 2025. The macroeconomic forecast as of December 31, 2020 considered the COVID-19 vaccine progress as well as anticipated government stimulus plans; however, uncertainty remained over the time necessary to return the economy to pre-pandemic levels.

The Bank recognized net charge-offs of $3.2 million during the year ended December 31, 2020 primarily due to a commercial and industrial charge-off of $1.7 million related to issues surrounding control of the underlying loan collateral. The Bank determined it appropriate to charge-off this entire loan relationship balance and pursue an aggressive collection strategy. Net charge-offs also included two commercial and industrial loan relationships totaling $447,000 as a result of impacts from the COVID-19 pandemic, a partial charge-off of one commercial and multifamily real estate construction and land development loan totaling $417,000 as a result of cost overruns and delays in construction and small dollar net charge-offs on a large volume of consumer loans of $884,000. Net charge-offs were offset partially by the full recovery of a commercial and industrial agricultural lending relationship of $963,000 during the year ended December 31, 2020, which was charged-off during the year ended December 31, 2019.

Based on the Bank's established comprehensive CECL methodology, management deemed the ACL on loans of $70.2 million at December 31, 2020 (1.57% of loans receivable and 120.82% of nonperforming loans) appropriate to provide for current expected credit losses in the loan portfolio. This compares to an ALL of $36.2 million (0.96% of loans receivable and 81.24% of nonperforming loans) at December 31, 2019 under the probable incurred loss methodology.

While we believe we used the best information available to determine the ACL on loans, our results of operations could be significantly affected if circumstances differ substantially from the assumptions used in determining the allowance. A further decline in national and local economic conditions, as a result of the COVID-19 pandemic or other factors, could result in a material increase in the ACL on loans and may adversely affect the Company’s financial condition and results of operations. In addition, the determination of the amount of the ACL on loans is subject to review by bank regulators, as part of their routine examination process, which may result in the establishment of an additional ACL on loans based upon their judgment of information available to them at the time of their examination. Because future events affecting borrowers and collateral cannot be predicted with certainty, there can be no assurance that the existing ACL on loans is appropriate or that increased provisions will not be necessary should the quality of the loans deteriorate. Any material increase in the ACL on loans could adversely affect the Company’s financial condition and results of operations.

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Deposits and Other Borrowings Overview

Total deposits increased $1.02 billion, or 22.2%, to $5.60 billion at December 31, 2020 from $4.58 billion at December 31, 2019 due primarily to proceeds from SBA PPP loans deposited directly into the customers' deposit accounts, an increase in customer deposit accounts based on changes in spending habits during the COVID-19 pandemic, and an increase in new deposit accounts. At December 31, 2020, the Bank had approximately 473 deposit accounts with balances of approximately $80.5 million related to new customers that received a SBA PPP loan from the Bank. The increase in total deposits included an increase in noninterest bearing demand deposits of $534.0 million, or 36.9%, to $1.98 billion at December 31, 2020 from $1.45 billion at December 31, 2019, in interest bearing demand deposits of $367.3 million, or 27.2%, to $1.72 billion at December 31, 2020 from $1.35 billion at December 31, 2019 and in money market accounts of $209.3 million, or 27.8%, to $963.0 million at December 31, 2020 from $753.7 million at December 31, 2019. These increases were offset partially by a decrease in certificates of deposit accounts of $125.0 million, or 23.8%, to $399.5 million at December 31, 2020 from $524.6 million at December 31, 2019. Non-maturity deposits as a percentage of total deposits increased to 92.9% at December 31, 2020 from 88.6% at December 31, 2019 and the percentage of certificates of deposit to total deposits decreased to 7.1% at December 31, 2020 from 11.4% at December 31, 2019 due primarily to promotional certificates of deposit balances maturing during the year ended December 31, 2020.

The following table summarizes the Company's deposits at the dates indicated:

Balance Percent of Total Balance Percent of Total Balance Percent of Total

(Dollars in thousands)

The following table provides the average balances outstanding and the weighted average interest rates for each major category of deposits for the periods indicated:

Year Ended December 31,

(Dollars in thousands)

The following table shows the amount and maturity of certificate of deposit accounts of $100,000 or more:

(In thousands)

Remaining maturity:

Three months or less $ 73,539

Over three months through six months 56,116

Over six months through twelve months 84,967

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Borrowings may be used on a short-term basis to compensate for reductions in other sources of funds (such as deposit inflows at less than projected levels). Borrowings may also be used on a longer-term basis to support expanded lending activities and match the maturity of repricing intervals of assets. The Bank also utilizes securities sold under agreement to repurchase as a supplement to its funding sources, whichare secured by available for sale investment securities. As of December 31, 2020 and December 31, 2019, only three customers utilized this product with total balances of $35.7 million at December 31, 2020, an increase of $15.5 million, or 76.9%, from $20.2 million at December 31, 2019 due primarily to customer activity during the period.

The Company also has junior subordinated debentures with a par value of $25.0 million which pay quarterly interest based on three-month LIBOR plus 1.56%. The debentures mature in 2037. The balance of the junior subordinated debentures was $20.9 million at December 31, 2020, which reflects the fair value of the junior subordinated debentures established as part of the merger with Washington Banking Company on May 1, 2014, adjusted for the accretion of discount from purchase accounting fair value adjustment.

At December 31, 2020, the Bank maintained credit facilities with the FHLB for $991.7 million and credit facilities with the Federal Reserve Bank for $54.3 million. The Company had no FHLB or Federal Reserve Bank advances outstanding at both the years ended December 31, 2020 and 2019. The average balance of FHLB advances and other borrowings was $1.5 million and $11.9 million during the years ended December 31, 2020 and 2019, respectively.

The Bank also maintains lines of credit with five correspondent banks to purchase federal funds totaling $215.0 million as of December 31, 2020. There were no federal funds purchased as of December 31, 2020 or December 31, 2019 and the lines were not utilized during the years ended December 31, 2020 and 2019.

The Bank was approved to utilize the PPPLF during the year ended December 31, 2020; however, the Bank chose not to participate.

Stockholders' Equity and Regulatory Capital Requirements Overview

Stockholders’ equity was $820.4 million at December 31, 2020 compared to $809.3 million at December 31, 2019. The Company’s stockholders' equity to assets ratio was 12.4% as of December 31, 2020 and 14.6% as of December 31, 2019. The following table reflects the changes to stockholders' equity during the periods indicated:

Year Ended December 31,

(In thousands)

Cumulative effect from change in accounting policy (1) (5,615) (399)

Other comprehensive income, net of tax 14,640 17,833

(1) Effective January 1, 2020, the Company adopted ASU 2016-13, Financial Instruments - Credit Losses. Effective January 1, 2019, the Company adopted ASU 2016-02, Leases.

During the year ended December 31, 2020, the Company repurchased the remaining 639,922 shares available under the eleventh stock repurchase plan at a weighted average price per share of $23.95 and repurchased 155,778 shares at a weighted average share price of $20.34 under the twelfth stock repurchase plan, which is a total of 795,700 shares under both plans at a weighted average share price of $23.25.

During the year ended December 31, 2019, the Company repurchased 292,712 shares available under the eleventh stock repurchase plan at a weighted average price per share of $26.50. No shares were repurchased under the eleventh stock repurchase plan during the year ended December 31, 2018.

The Company has historically paid cash dividends to its common shareholders. Payments of future cash dividends, if any, will be at the discretion of our Board of Directors after taking into account various factors, including our business, operating results and financial condition, capital requirements, current and anticipated cash needs, plans for expansion, any legal or contractual limitation on our ability to pay dividends and other relevant factors. Dividends on common stock from the Company depend substantially upon receipt of dividends from the Bank, which is the Company’s predominant source of income. On January 27, 2021, the Company’s Board of Directors declared a regular quarterly dividend of $0.20 per common share payable on February 24, 2021 to shareholders of record on February 10, 2021.

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Year Ended December 31,

Dividends paid per common share $ 0.80 $ 0.84 $ 0.72

(1) Dividend payout ratio is declared dividends per common share divided by diluted earnings per common share.

The Company is a bank holding company under the supervision of the Federal Reserve Bank. Bank holding companies are subject to capital adequacy requirements of the Federal Reserve under the Bank Holding Company Act of 1956, as amended, and the regulations of the Federal Reserve. Heritage Bank is a federally insured institution and thereby is subject to the capital requirements established by the FDIC. The Federal Reserve capital requirements generally parallel the FDIC requirements. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Consolidated Financial Statements. Management believes that as of December 31, 2020, the Company and the Bank meet all capital adequacy requirements to which they are subject. For additional information regarding the Company’s and the Bank’s regulatory capital requirements, see “Supervision and Regulation-Capital Adequacy” in Item 1. Business and Note (22) Regulatory Capital Requirements included in Item 8. Financial Statements And Supplementary Data.

Off-Balance Sheet Arrangements

In the ordinary course of business, we enter into various types of transactions that include commitments to extend credit that are not included in our Consolidated Financial Statements. We apply the same credit standards to these commitments as we use in all our lending activities and have included these commitments in our lending risk evaluations. Our exposure to credit loss under commitments to extend credit is represented by the amount of these commitments. The Company had off-balance sheet loan commitments, including letters of credit, of $1.11 billion at December 31, 2020, a decrease of $106.9 million, or 8.8%, from $1.21 billion at December 31, 2019. For additional information, see Note (15) Commitments and Contingencies included in Item 8. Financial Statements And Supplementary Data.

Average Balances, Yields and Rates Paid for the Years Ended December 31, 2020, 2019 and 2018

Our core profitability depends primarily on our net interest income, which is the difference between the income we receive on our loan and investment portfolios, and our interest expense, which consists of interest paid on deposits and borrowed funds. Like most financial institutions, our interest income and interest expense are affected significantly by general economic conditions, particularly changes in market interest rates and government policies.

Changes in net interest income result from changes in volume, net interest spread, and net interest margin. Volume refers to the average dollar amounts of interest earning assets and interest bearing liabilities. Net interest spread refers to the difference between the average yield on interest earning assets and the average cost of interest bearing liabilities. Net interest margin refers to net interest income divided by average interest earning assets and is influenced by the level and relative mix of interest earning assets and interest bearing and noninterest bearing liabilities.

The following table provides relevant net interest income information for periods indicated:

Year Ended December 31,

(Dollars in thousands)

Interest Earning Assets:

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Year Ended December 31,

(Dollars in thousands)

Interest Bearing Liabilities:

(1)The average loan balances presented in the table are net of ACL on loans. Nonaccrual loans have been included in the table as loans carrying a zero yield.

(2)Yields on tax-exempt securities and loans have not been stated on a tax-equivalent basis.

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The following table provides the amount of change in our net interest income attributable to changes in volume and changes in interest rates. Changes attributable to the combined effect of volume and interest rates have been allocated proportionately for changes due specifically to volume and interest rates.

Year Ended December 31,

Volume Rate Total Volume Rate Total

(Dollars in thousands)

Interest Earning Assets:

Interest Bearing Liabilities:

Securities sold under agreement to repurchase (4) (11) (15) (18) 111 93

(1) The average loan balances presented in the table are net of ACL on loans. Nonaccrual loans have been included in the table as loans carrying a zero yield.

(2) Yields on tax-exempt securities and loans have not been stated on a tax-equivalent basis.

Earnings Summary

Results of Operations for the Years Ended December 31, 2020 and 2019

Net income was $46.6 million, or $1.29 per diluted common share, for the year ended December 31, 2020 compared to $67.6 million, or $1.83 per diluted common share, for the year ended December 31, 2019. Net income decreased $21.0 million, or 31.1%, for the year ended December 31, 2020 compared to the year ended December 31, 2019 primarily due to an increase in the provision for credit losses of $31.8 million as a result of estimated credit losses forecasted due to the COVID-19 pandemic and its impact on the economy, offset partially by a decrease in income tax expense of $6.9 million due to lower pre-tax income as well as a provision in the CARES Act permitting the recognition of a benefit from net operating losses related to prior acquisitions.

The net interest margin decreased 59 basis points to 3.63% for the year ended December 31, 2020 compared to 4.22% for the year ended December 31, 2019.The decrease in net interest margin was due primarily to decreases in yields of total interest earning assets as a result of decreases in short-term market interest rates and changes in the mix of total interest earning assets, including the origination of lower-yielding SBA PPP loans with an average balance of $589.6 million, offset partially by decreases in the cost of total interest bearing liabilities during the year ended December 31, 2020.

The Company’s efficiency ratio was 62.52% for the year ended December 31, 2020 compared to 63.23% for the year ended December 31, 2019. The improvement in the efficiency ratio was primarily due to the increase in noninterest income.

Net Interest Income Overview

One of the Company's key sources of earnings is net interest income. There are several factors that affect net interest income, including, but not limited to, the volume, pricing, mix and maturity of interest earning assets and interest bearing liabilities; the volume of noninterest earning assets, noninterest bearing demand deposits, other noninterest bearing liabilities and stockholders' equity; market interest rate fluctuations; and asset quality.

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Market rates impact the results of the Company's net interest income, including the significant decreases in the federal funds target rate by the Federal Reserve in response to the COVID-19 pandemic during March 2020. The following table provides the federal funds target rate history and changes from each period since December 31, 2018:

Change Date Rate (%) Rate Change (%)

Net interest income increased $1.3 million, or 0.7%, to $201.0 million for the year ended December 31, 2020 compared to $199.7 million for the year ended December 31, 2019. The increase in net interest income was primarily due to an increase in the average balance of total interest earning assets and a decrease in the cost of total interest bearing liabilities. These increases were offset partially by decreases in the yield on interest earning assets following the decreases in market rates identified in the table above.

Interest Income

Total interest income decreased $3.5 million, or 1.6%, to $214.3 million for the year ended December 31, 2020 compared to $217.9 million for the year ended December 31, 2019 due primarily to decreases in yields on adjustable rate instruments following several decreases in short-term market rates, offset partially by increases in the average balance of total interest earning assets, primarily due to the originations of SBA PPP loans and increases in interest earning deposits. The yield on total interest earning assets decreased 74 basis points to 3.87% for the year ended December 31, 2020 compared to 4.61% for the year ended December 31, 2019. The balance of average total interest earning assets increased $805.4 million, or 17.0%, to $5.54 billion for the year ended December 31, 2020 from $4.73 billion for the year ended December 31, 2019, including increases in the average balance of SBA PPP loans of $589.6 million and interest earning deposits of $217.7 million.

Interest income from interest and fees on loans increased $2.9 million, or 1.5%, to $192.4 million for the year ended December 31, 2020 from $189.5 million for the year ended December, 31, 2019 due primarily to an increase in the average balance of loans receivable, net, offset by decreases in the loan yield. Average loans receivable, net increased $666.9 million, or 18.2%, to $4.34 billion for the year ended December 31, 2020 compared to $3.67 billion for the year ended December 31, 2019 due primarily to the impact of SBA PPP loans. There were no SBA PPP loans outstanding during the year ended December 31, 2019. Loan yield decreased 73 basis points to 4.44% for the year ended December 31, 2020 from 5.17% for the year ended December 31, 2019 due primarily to the multiple and sustained decreases in short-term market rates and secondarily due to the impact of low-yielding SBA PPP loans. Loan yield, excluding SBA PPP loans and incremental accretion on purchased loans, decreased 52 basis points to 4.52% for the year ended December 31, 2020 compared to 5.04% for the year ended December 31, 2019. SBA PPP loans had a negative impact on loan yield of 16 basis points as a result of the low-yielding 1% loan interest rate, offset by the impact of the deferred fee which increased the yield to 3.30% for the year ended December 31, 2020.

Incremental accretion represents the amount of interest income recorded on purchased loans in excess of the contractual stated interest rate in the individual loan notes due to incremental accretion of purchased discount or premium. Purchased discount or premium is the difference between the contractual loan balance and the fair value of acquired loans at the acquisition date, or as modified by CECL Adoption. The purchased discount is accreted into income over the remaining life of the loan. The impact of incremental accretion on loan yield will change during any period based on the volume of prepayments, but it is expected to decrease over time as the balance of the purchased loans decreases. Incremental accretion income was $3.4 million and $4.9 million for the years ended December 31, 2020 and 2019, respectively. The impact on loan yield from incremental accretion on purchased loans was 0.08% and 0.13% for the years ended December 31, 2020 and 2019, respectively. The incremental accretion and the impact to loan yield will change during any year based on the volume of prepayments, but is expected to decrease over time as the balance of the purchased loans continues to decrease. At December 31, 2020 and December 31, 2019, the remaining unamortized net purchase discount was $6.6 million and $8.4 million, respectively.

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The following table presents the loan yield and the impacts of the balances and interest and fees earned on SBA PPP loans and the incremental accretion on purchased loans on this financial measure for the periods presented below:

Year Ended December 31,

(Dollars in thousands)

Non-GAAP reconciliation of loan yield:(1)

Loan yield (GAAP) 4.44 % 5.17 %

Exclude Impact on loan yield from SBA PPP loans 0.16 % — %

(1) For additional information, see "Reconciliations of Non-GAAP Measures" section below.

Interest income on investment securities decreased $5.2 million, or 19.8%, to $21.2 million for the year ended December 31, 2020 compared to $26.4 million for the year ended December 31, 2019 due to a combination of decreases in yield and average balance. The yield on the aggregate investment portfolio decreased 35 points to 2.40% for the year ended December 31, 2020 from 2.75% for the same period in 2019, including decreases of 38 basis points and 11 basis points on the yield on taxable securities and nontaxable securities, respectively. The decrease in yield was due primarily to decreases in market rate on adjustable securities and secondarily due to lower yields on current year purchases of investment securities compared to the existing portfolios. Also contributing to the decline in interest income on investment securities was a decrease in the average balance of total investment securities of $79.2 million, or 8.2%, to $883.8 million for the year ended December 31, 2020 from $963.1 million for the year ended December 31, 2019 due primarily to principal reduction from prepayments and calls of securities as a result of the currently low interest rate environment.

Interest income on interest earning deposits decreased $1.2 million, or 62.9%, to $703,000 during the year ended December 31, 2020 compared to $1.9 million for the year ended December 31, 2019 due to a decrease in the yield on interest earning deposits, offset partially by an increase in the average balance. The yield on interest earning deposits decreased 171 basis points to 0.22% for the year ended December 31, 2020 compared to 1.93% for the year ended December 31, 2019 due to decreases in short-term market rates. The average balance of interest earning deposits increased $217.7 million, or 221.8%, to $315.8 million for the year ended December 31, 2020 compared to $98.2 million for the year ended December 31, 2019 due primarily to excess liquidity.

Interest Expense

Total interest expense decreased $4.8 million, or 26.7%, to $13.3 million for the year ended December 31, 2020 compared to $18.2 million for the year ended December 31, 2019 due primarily to decreases in market interest rates following decreases in the federal funds target rate mentioned previously, offset partially by an increase in the average balance of total interest bearing liabilities. The cost of total interest bearing liabilities decreased 20 basis points to 0.38% for the year ended December 31, 2020 from 0.58% for the year ended December 31, 2019. The average balance of total interest bearing liabilities increased $381.1 million, or 12.2%, to $3.51 billion for the year ended December 31, 2020 from $3.13 billion for the year ended December 31, 2019.

Interest expense on total interest bearing deposits decreased $4.1 million, or 25.0%, to $12.3 million for the year ended December 31, 2020 compared to $16.3 million for the year ended December 31, 2019 due primarily to decreases in market interest rates, offset partially by an increase in the average balance. The cost of total interest bearing deposits decreased 18 basis points to 0.35% for the year ended December 31, 2020 from 0.53% for the year ended December 31, 2019 due primarily to a decrease in the cost of savings accounts of 41 basis points to 0.11% for the year ended December 31, 2020 from 0.52% for the year ended December 31, 2019 and secondarily to a decrease in the cost of certificates of deposits of 19 basis points to 1.18% from 1.37% for the years ended December 31, 2020 and 2019, respectively. The decrease in cost of total interest bearing deposits was offset partially by an increase in the average balance of total interest bearing deposits of $391.9 million, or 12.8%, to $3.46 billion for the year ended December 31, 2020 compared to $3.07 billion for the year ended December 31, 2019 as a result of the Bank's participation in the SBA's PPP as well as a change in customer's spending behaviors due to the COVID-19 pandemic and new deposit accounts.

The Company's deposit costs were favorably impacted by the increase in the average balance of noninterest bearing demand deposits compared to total interest bearing deposits. The average balance of noninterest bearing demand deposits increased $445.4 million, or 32.1%, to $1.84 billion for the year ended December 31, 2020 compared to $1.39 billion for the year ended December 31, 2019. The increase in the average balance of noninterest bearing deposits caused a decrease in the total cost of all deposits of 14 basis points to 0.23% for the year ended December 31, 2020 from 0.37% for the same period in 2019.

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Provision for Credit Losses Overview

Effective January 1, 2020, CECL Adoption replaced the ALL with the ACL on loans and replaced the related provision for loan losses with the provision for credit losses on loans. CECL Adoption also replaced the allowance for unfunded commitments with the ACL on unfunded commitments and replaced the related provision for unfunded commitments with the provision for credit losses on unfunded commitments. The aggregate of the provision for credit losses on loans and the provision for credit losses on unfunded commitments is presented on the Consolidated Statements of Income as the provision for credit losses. The ACL on unfunded commitments is included on the Consolidated Statements of Financial Condition within accrued expenses and other liabilities. For additional information, see “—Critical Accounting Policies” above.

The following table presents the provision for credit losses for the periods indicated:

Year Ended December 31,

(In thousands)

Provision for credit losses on loans $ 35,433 $ 4,311

Provision for credit losses on unfunded commitments 673 —

Provision for Credit Losses on Loans

The Bank has established a comprehensive methodology for determining its ACL on loans. The ACL on loans is increased by the provision for credit losses on loans which is charged against earnings. The amount of the provision expense recognized during the year ended December 31, 2020 was calculated based on a thorough review of the loan portfolio and in accordance with the Bank's CECL methodology for determining the current expected credit losses on loans. The amount of the provision expense recognized during the year ended December 31, 2019 was calculated in accordance with the Bank's probable incurred loss methodology. For additional information, see the section entitled "Analysis of Allowance for Credit Losses on Loans" above.

The provision for credit losses on loans is dependent on the Bank’s ability to manage asset quality and control the level of net charge-offs through prudent underwriting standards. In addition, a further decline in general economic conditions, including as a result of the COVID-19 pandemic, could increase future provisions for credit losses on loans and have a material adverse effect on the Company’s net income.

The provision for credit losses on loans increased $31.1 million, or 721.9%, to $35.4 million for the year ended December 31, 2020 from $4.3 million for the year ended December 31, 2019 due primarily to the credit deterioration estimated as a result of the COVID-19 pandemic, as further explained in the "Analysis of Allowance for Credit Losses on Loans" above. Additionally, the Bank recorded net charge-offs of $3.2 million during both the years ended December 31, 2020 and 2019, increasing the need for provision expense.

Provision for Credit Losses on Unfunded Commitments

The Bank has established a comprehensive methodology for determining its ACL on unfunded commitments, which is similar to the ACL on loans with additional considerations for the likelihood of funding over the contractual life of the commitment. The ACL on unfunded commitments is increased by the provision for credit losses on unfunded commitments which is charged against earnings. The amount of the provision expense recognized during the year ended December 31, 2020 was calculated based on a thorough review of the loan portfolio and in accordance with the Bank's CECL methodology for determining the current expected credit losses on unfunded commitments. The amount of the provision expense recognized during the year ended December 31, 2019 was calculated in accordance with the Bank's incurred loss methodology.

The Bank recorded a provision for credit losses on unfunded commitments of $673,000 during the year ended December 31, 2020 primarily as a result of an increased in the estimated losses as a result of credit deterioration due to the COVID-19 pandemic (as reflected in the ACL on loans) and partially offset a decrease in the utilization rates for revolving lines of credit to 38.6% at December 31, 2020 compared to 39.2% at December 31, 2019.

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Noninterest Income Overview

Total noninterest income increased $4.8 million, or 14.7%, to $37.2 million for the year ended December 31, 2020 compared to $32.5 million for the same period in 2019. The following table presents the change in the key components of noninterest income for the periods noted:

Year Ended December 31,

(Dollars in thousands)

Gain on sale of loans, net increased $2.6 million, or 108.1%, to $5.0 million for the year ended December 31, 2020 compared to $2.4 million for the same period in 2019 from the combination of higher origination and sales volumes and higher earned sales margins reflecting an increased demand for residential loans due to the low interest rate environment during the year ended December 31, 2020. Originations of mortgage loans held for sale increased $64.9 million, or 90.1%, to $137.0 million for the year ended December 31, 2020 from $72.2 million for the year ended December 31, 2019.

Bank owned life insurance income increased $2.2 million, or 100.0%, to $4.3 million during the year ended December 31, 2020 compared to $2.2 million during the year ended December 31, 2019 due primarily to life insurance death benefit income of $1.9 million recognized during the year ended December 31, 2020. No death benefits were recognized during the year ended December 31, 2019.

Gain on sale of investment securities, net increased $1.2 million, or 360.0%, to $1.5 million for the year ended December 31, 2020 from $330,000 during the same period in 2019 as a result of the Bank's active management of the investment portfolio in the current low interest rate environment.

Other income increased $825,000, or 10.8%, to $8.4 million for the year ended December 31, 2020 compared to $7.6 million for the year ended December 31, 2019 primarily as a result of a net gain on sale of two branches held for sale of $935,000 and a termination fee from the divestiture of our trust department of $651,000, offset partially by a counterparty valuation adjustment on our back-to-back interest rate swaps of $422,000 due to the lower interest rate environment.

The increase in noninterest income was offset partially by a decrease in service charges and other fees of $2.5 million, or 13.3%, to $16.2 million for the year ended December 31, 2020 compared to $18.7 million for the year ended December 31, 2019 due primarily to a decrease in overdraft fees of $1.8 million and decreases in other activity-based fees on deposit accounts based on changes in customer spending habits as a result of the COVID-19 pandemic.

Noninterest Expense Overview

Noninterest expense increased $2.2 million, or 1.5%, to $148.9 million during the year ended December 31, 2020 compared to $146.8 million for the year ended December 31, 2019. The following table presents changes in the key components of noninterest expense for the periods indicated:

Year Ended December 31,

(Dollars in thousands)

State/municipal business and use tax 3,754 3,754 — —

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Year Ended December 31,

(Dollars in thousands)

Federal deposit insurance premium expense increased $1.1 million, or 146.8%, to $1.8 million during the year ended December 31, 2020 from $725,000 during the year ended December 31, 2019 due primarily to the impact of the decrease in the Bank's Tier 1 leverage ratio on the Bank's assessment rate, offset partially by the use of a small bank credit of $518,000 during the year ended December 31, 2020 compared to $726,000 during the year ended December 31, 2019. All small bank credits were fully utilized as of December 31, 2020.

Occupancy and equipment increased $974,000, or 4.5%, to $22.7 million during the year ended December 31, 2020 from $21.7 million during the year ended December 31, 2019 due primarily to costs, including depreciation expense, related to the Southern Operations Center location placed into operation in December 2019.

Professional services increased $729,000, or 14.0%, to $5.9 million during the year ended December 31, 2020 from $5.2 million during the year ended December 31, 2019 related primarily to the launch of the new mobile and online commercial banking platform, "Heritage Direct." The implementation of the new banking platform was completed during the second quarter of 2020.

The increases in noninterest expense were partially offset by a decrease in expense on other real estate owned, net of $497,000, or 141.2%, to a net gain of $145,000 during the year ended December 31, 2020 from a net expense of $352,000 during the year ended December 31, 2019 as a result of net gain on sales recognized during the year ended December 31, 2020 compared to net loss on sales recognized during the year ended December 31, 2019.

The ratio of noninterest expense to average total assets was 2.37% for the year ended December 31, 2020 compared to 2.71% for the year ended December 31, 2019. The decrease in the ratio of noninterest expense to average total assets was primarily due to an increase in average total assets as discussed in the Net Interest Income Overview section.

Income Tax Expense Overview

Income tax expense decreased $6.9 million, or 51.0%, to $6.6 million for the year ended December 31, 2020 from $13.5 million for the year ended December 31, 2019. The effective tax rate was 12.4% for the year ended December 31, 2020 compared to 16.6% for the year ended December 31, 2019. The decrease in income tax expense and effective tax rate during the year ended December 31, 2020 was primarily due to a provision in the CARES Act which permitted the Company to recognize a $1.0 million benefit from net operating losses related to prior acquisitions during the year ended December 31, 2020 and secondarily due to a decrease in pre-tax income which increased the impact of favorable permanent tax items such as tax-exempt investments, investments in bank owned life insurance and low-income housing tax credits.

Reconciliations of Non-GAAP Measures

This section contains certain financial information determined by methods other than in accordance with GAAP. Our management uses these non-GAAP measures, together with the related GAAP measures, in its analysis of our performance and in making business decisions. Management also uses these measures for peer comparisons. Management believes that presenting loan yield excluding the effect of discount accretion on purchased loans is useful in assessing the impact of acquisition accounting on loan yield as the effect of loan discount accretion is expected to decrease as the acquired loans mature or roll off our balance sheet. Management believes that presenting loan yield excluding the effect of SBA PPP loans is useful in assessing the impact of the special program loans that are anticipated to substantially decrease upon forgiveness by the SBA within a short time frame. This also applies to the ratio of ACL on loans to loans receivable excluding the effect of SBA PPP. Management believes that presenting pre-tax pre-provision income, which reflects our profitability before income taxes and provision for credit losses, is useful in assessing our operating income and expenses by removing the volatility that is associated with credit loss provisions. We also believe that during a crisis such as the COVID-19 pandemic, this information is useful as the impact of the pandemic on credit loss provisions of various institutions will likely vary based on the geography of the communities served by a particular institution, and the decision to adopt or defer ASC 2016-13. These non-GAAP measures have inherent limitations, are not required to be uniformly applied and are not audited. They should not be considered in isolation or as substitutes for the results determined to be in accordance with GAAP, nor are they necessarily comparable to non-GAAP performance measures that may be presented by other companies. Where applicable, comparable earnings information using GAAP financial measures is also presented.

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Reconciliations of the GAAP and non-GAAP financial measures are presented below for the periods indicated:

Year Ended December 31,

(Dollars in thousands)

Exclude SBA PPP loan interest and fees (19,472) —

Exclude incremental accretion on purchased loans (3,446) (4,876)

Adjusted interest and fees on loans (non-GAAP) $ 169,499 $ 184,639

Exclude average SBA PPP loans (589,635) —

Adjusted average loans receivable, net (non-GAAP) $ 3,745,929 $ 3,668,665

Loan yield (GAAP) 4.44 % 5.17 %

Year Ended December 31,

(Dollars in thousands)

ACL on loans to loans receivable, excluding SBA PPP loans

Allowance for credit losses on loans $ 70,185 $ 36,171

Exclude SBA PPP loans 715,121 —

ACL on loans to Loans receivable (GAAP) 1.57 % 0.96 %

Year Ended December 31,

(Dollars in thousands)

Pre-tax, Pre-provision Income:

Liquidity and Capital Resources

Our primary sources of funds are customer and local government deposits, loan principal and interest payments, loan sales and interest earned on and proceeds from sales and maturities of investment securities. These funds, together with retained earnings, equity and other borrowed funds, are used to make loans, acquire investment securities and other assets, and fund continuing operations. While maturities and scheduled amortization of loans are a predictable source of funds, deposit flows and loan prepayments are greatly influenced by the level of interest rates, economic conditions and competition.

We are required to maintain an adequate level of liquidity to ensure the availability of sufficient funds for loan originations and deposit withdrawals, satisfy other financial commitments, and fund operations. We generally maintain sufficient

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cash and investments to meet short-term liquidity needs. At December 31, 2020, cash and cash equivalents totaled $743.3 million, or 11.2%, of total assets. Investment securities available for sale totaled $802.2 million at December 31, 2020, of which $194.9 million were pledged to secure public deposits, borrowing arrangements or securities sold under agreement to repurchase. Management considers unpledged investment securities available for sale to be a viable source of liquidity. The fair value of investment securities available for sale that were unpledged totaled $607.3 million, or 9.2% of total assets at December 31, 2020. The fair value of investment securities available for sale with maturities of one year or less totaled $56.1 million, or 0.8% of total assets at December 31, 2020. At December 31, 2020, the Bank maintained credit facilities with the FHLB for $991.7 million and credit facilities with the Federal Reserve Bank for $54.3 million, of which there were no borrowings outstanding under either facility as of December 31, 2020. The Bank also maintains advance lines with Wells Fargo Bank, US Bank, The Independent Bankers Bank, Pacific Coast Bankers’ Bank, and JP Morgan Chase to purchase federal funds totaling $215.0 million as of December 31, 2020, of which there were none outstanding as of December 31, 2020.

Our strategy has been to acquire non-maturity deposits from our retail accounts, acquire noninterest bearing demand deposits from our commercial customers, and use our available borrowing capacity to fund growth in assets. We anticipate that we will continue to rely on the same sources of funds in the future and use those funds primarily to make loans and purchase investment securities.

Contractual Obligations

The following table provides the amounts due under specified contractual obligations for the periods indicated as of December 31, 2020:

(In thousands)

Contractual payments by period:

Securities sold under agreement to repurchase — — — — 35,683 35,683

Junior subordinated debentures — — — 25,000 — 25,000

(1)Represents noninterest bearing demand deposits, interest bearing demand deposits, money market accounts and savings accounts which can generally be withdrawn on demand and thereby have an undefined maturity.

Asset and Liability Management

Our primary financial objective is to achieve long-term profitability while controlling our exposure to fluctuations in market interest rates. To accomplish this objective, we have formulated an interest rate risk management policy that attempts to manage the mismatch between asset and liability maturities while maintaining an acceptable interest rate sensitivity position. The principal strategies which we employ to control our interest rate sensitivity are: originating certain commercial business loans and real estate construction and land development loans at variable interest rates repricing for terms generally one year or less; and offering noninterest bearing demand deposit accounts to businesses and individuals. The longer-term objective is to increase the proportion of noninterest bearing demand deposits and low-rate interest bearing demand deposits, money market accounts, and savings deposits relative to certificate of deposit accounts to reduce our overall cost of funds.

A number of measures are used to monitor and manage interest rate risk, including income simulations, interest sensitivity (gap) analysis and economic value of equity sensitivity. An income simulation model is the primary tool used to assess the direction and magnitude of changes in net interest income resulting from changes in interest rates. Key assumptions in the model include prepayment speeds on loans and investment securities, decay rates on non-maturity deposits, and pricing on investment securities, loans, deposits and borrowings. In order to measure the interest rate risk sensitivity as of December 31, 2020, this simulation model uses a “no growth” assumption and assumes an instantaneous and sustained uniform change in market interest rates at all maturities. These assumptions are inherently uncertain and, as a result, the net interest income projections should be viewed as an estimate of the net interest income sensitivity at the time of the analysis. Actual results will differ from simulated results due to timing, magnitude and frequency of interest rate changes and changes in market conditions and management strategies, among other factors.

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Based on the results of the simulation model, the following table presents the change in our net interest income as a result of parallel rate shock scenarios for the presented periods after the dates shown:

(Dollars in thousands)

Modeled increase in market interest rates of 100 basis points

Increase in net interest income in Year 1 $ 15,281 $ 8,149

Modeled increase in market interest rates of 200 basis points

Modeled decrease in market interest rates of 100 basis points

Decrease in net interest income in Year 1 (3,014) (7,415)

Decrease in net interest income in Year 2 (7,034) (15,178)

These scenarios are based on interest rates as of the last day of a reporting period published by independent sources and incorporate relevant spread of instruments that are actively traded in the open market. Given that the short-term rates have drastically declined during the year ended December 31, 2020, we do not believe that the results of the "Down 200" analysis provide meaningful output and have been excluded. For the "Down 100" scenario, the Bank's modeling assumption is that all deposit rates are floored to one or two basis points and new loan production is recalibrated to incorporate a chosen net interest spread over index. The simulations used to manage market risk are based on numerous assumptions regarding the effect of changes in interest rates on the timing and extent of reprice characteristics, future cash flows and customer behavior. These assumptions are inherently uncertain and, as a result, the model cannot precisely estimate net interest income or precisely predict the impact of higher or lower net interest income. Actual results will differ from simulated results due to the timing, magnitude, and frequency of interest rate changes as well as changes in market condition, customer behavior and management strategies, among other factors.

Our asset and liability management strategies have resulted in a negative three month or less “gap” of 30.8% as of December 31, 2020. This “gap” measures the difference between the dollar amount of our interest earning assets and interest bearing liabilities that mature or reprice within the designated period (three months or less) as a percentage of total interest earning assets, based on certain estimates and assumptions as discussed below. We believe that the implementation of our operating strategies has reduced the potential effects of changes in market interest rates on our results of operations. The negative gap for the three month or less period indicates that decreases in market interest rates may favorably affect our results over that period.

The following table provides the estimated maturity or repricing and the resulting interest rate sensitivity gap of our interest earning assets and interest bearing liabilities at December 31, 2020. We used certain assumptions in presenting this data so the amounts may not be consistent with other financial information prepared in accordance with generally accepted accounting principles. The amounts in the tables also could be significantly affected by external factors, such as changes in prepayment assumptions, early withdrawal of deposits and competition.

Estimated Maturity or Repricing Within

(Dollars in thousands)

Interest Earnings Assets:

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Estimated Maturity or Repricing Within

(Dollars in thousands)

Interest Bearing Liabilities:

Junior subordinated debentures 20,887 — — — — 20,887

Securities sold under agreement to repurchase 35,683 — — — — 35,683

(1)Adjustable-rate liabilities are included in the period in which interest rates are next scheduled to adjust rather than in the period they are due to mature. Although noninterest demand deposits, interest bearing demand deposits, money market accounts, and saving accounts are subject to immediate withdrawal, based on historical experience, management considers a substantial amount of such accounts to be core deposits having significantly longer maturities.

Certain shortcomings are inherent in the method of analysis presented in the foregoing table. For example, although certain assets and liabilities may have similar maturities or periods to repricing, they may react in different degrees to changes in market interest rates. Also, the interest rates on some types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types may lag behind changes in market interest rates. Additionally, some assets, such as adjustable rate residential real estate mortgages, have features, which restrict changes in the interest rates of those assets both on a short-term basis and over the lives of such assets. Further, if a change in market interest rates occurs, prepayment and early withdrawal levels could deviate significantly from those assumed in calculating the tables. Finally, the ability of many borrowers to service their adjustable rate debt may decrease if market interest rates increase substantially.

The table below provides information about our financial instruments that are sensitive to changes in interest rates as of December 31, 2020. The table presents principal cash flows and related weighted average interest rates by expected maturity dates. The expected maturity is the contractual maturity or earlier call date of the instrument. The data in this table may not be consistent with the amounts in the preceding table, which represents amounts by the estimated repricing date or maturity date, whichever occurs sooner.

By Expected Maturity Date

(Dollars in thousands)

Investment Securities

Amounts maturing:

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By Expected Maturity Date

(Dollars in thousands)

Loans Receivable

Amounts maturing:

Certificate of Deposit Accounts

Amounts maturing:

Junior Subordinated Debentures

Amounts maturing:

Weighted average interest rate (1) — % — % — % — % 4.29 % 4.29 %

(1)The contractual interest rate of the junior subordinated debentures was 1.80% at December 31, 2020. The weighted average rate includes the accretion of the discount established at the merger date which is amortized over the life of the trust preferred securities.

Impact of Inflation and Changing Prices

Inflation affects our operations by increasing operating costs and indirectly by affecting the operations and cash flow of our customers. Unlike most industrial companies, virtually all the assets and liabilities of a financial institution are monetary in nature. As a result, changes in interest rates generally have a more significant impact on a financial institution’s performance than the effects of general levels of inflation. Although interest rates do not necessarily move in the same direction or the same extent as the prices of goods and services, increases in inflation generally have resulted in increased interest rates.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to interest rate risk through our lending and deposit gathering activities. For a discussion of how this exposure is managed and the nature of changes in our interest rate risk profile during the past year, see Item 7. Management’s Discussion And Analysis Of Financial Condition And Results Of Operations -— Asset and Liability Management.

Neither we, nor the Bank, maintain a trading account for any class of financial instrument, nor do we, or the Bank, engage in hedging activities or purchase high risk derivative instruments. Moreover, neither we, nor the Bank, are subject to foreign currency exchange rate risk or commodity price risk.

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ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Report of Independent Registered Public Accounting Firm

Stockholders and the Board of Directors of Heritage Financial Corporation

Olympia, Washington

Opinions on the Financial Statements and Internal Control over Financial Reporting

We have audited the accompanying ConsolidatedStatements of Financial Condition of Heritage Financial Corporation and Subsidiaries (the "Company") as of December 31, 2020 and 2019, the related Consolidated Statements of Income, Comprehensive Income, Stockholders’ Equity, and Cash Flows for each of the years in the three-year period ended December 31, 2020, and the related notes (collectively referred to as the "financial statements"). We also have audited the Company’s internal control over financial reporting as of December 31, 2020 based on criteria established in the 2013 Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”).

In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2020 and 2019, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2020 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2020 based on criteria established in the 2013 Internal Control – Integrated Framework issued by COSO.

Change in Accounting Principle

As discussed in Note 1 to the financial statements, the Company has changed its method of accounting for allowance for credit losses effective January 1, 2020 due to the adoption of Financial Accounting Standards Board Accounting Standards Codification No. 326, Financial Instruments – Credit Losses (ASC 326). The Company adopted the new current expected credit loss standard using the modified retrospective method such that prior period amounts are not adjusted and continue to be reported in accordance with previously applicable generally accepted accounting principles. The adoption of the new credit loss standard and its subsequent application is also communicated as a critical audit matter below.

Basis for Opinions

The Company’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s financial statements and an opinion on the Company’s internal control over financial reporting based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) ("PCAOB") and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.

We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud, and whether effective internal control over financial reporting was maintained in all material respects.

Our audits of the financial statements included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

Definition and Limitations of Internal Control Over Financial Reporting

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the

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company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

Critical Audit Matters

The critical audit matters communicated below are matters arising from the current period audit of the financial statements that were communicated or required to be communicated to the audit committee and that: (1) relate to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the financial statements, taken as a whole, and we are not, by communicating the critical audit matters below, providing separate opinions on the critical audit matters or on the accounts or disclosures to which they relate.

Allowance for Credit Losses on Loans – Modeling Techniques and Qualitative Risk Factor Adjustments

As described in Note 1, “Description of Business, Basis of Presentation, Significant Accounting Policies and Recently Issued Accounting Pronouncements” and Note 5, “Allowance for Credit Losses (“ACL”) on Loans” to the consolidated financial statements, the Company’s consolidated allowance for credit losses on loans was $70.2 million at December 31, 2020. Provision for credit losses on loans was $35.4 million for the year then ended. On January 1, 2020, the Company adopted ASC 326 which replaced the probable incurred loss methodology with an expected loss methodology that is referred to as the current expected credit loss (“CECL”) methodology. Upon adoption, the Company recorded a reduction to retained earnings, net of tax of $5.6 million, which includes the impact for both loans and unfunded commitments, as a cumulative-effect adjustment using a modified retrospective approach. See change in accounting principle explanatory paragraph above. The ACL on loans evaluation, upon adoption and at December 31, 2020, is inherently subjective, as it utilizes estimates that require a high degree of judgment relating to risk characteristics of loan segments, macroeconomic variables used in forecasting, and other qualitative risk factors. Changes in these judgments and estimates could have a material effect on the Company’s financial results.

The Company primarily uses a historic loss, open pool CECL methodology to calculate the ACL on loans, which the Company has applied to identified loan segments with similar risk characteristics. The methodology incorporates a macroeconomic sensitive model which calculates multipliers for each loan segment to account for the current and forecasted conditions that adjust the baseline historical loss rates over a reasonable and supportable forecast period. The forecasted segment balances are impacted by a mix of macroeconomic factors not limited to, but including unemployment rate, GDP, housing price index, commercial real estate price index, disposable income growth, mortgage rates, and certain rate indices. The macroeconomic sensitive model was developed utilizing regression analysis to determine the factors that were predictive of loss rates based on historical data for each forecasted segment. Regression modeling is a complex estimation approach for determining loss rates during the forecast period which required significant judgment by management. The process involved the selection of macroeconomic factors and the evaluation of regression analysis outputs to determine the statistical fit of each macroeconomic factor used to forecast expected losses in each statistically modeled portfolio segment.

The Company also utilizes qualitative risk factor adjustments to account for credit losses that are not inherently considered in the quantitative analyses. These adjustments are subjectively selected by management and are based on established metrics to estimate risk. The subjective nature of the qualitative risk factor adjustments requires significant judgment by management both in the selection of qualitative factors to apply, if any, and the magnitude of the adjustment once selected.

The audit procedures over the modeling techniques used to develop the macroeconomic sensitive model involved a high degree of auditor judgment and required significant audit effort including the use of more experienced audit personnel and internal credit and valuation specialists due to its complexity. Additionally, the audit procedures over the qualitative adjustments utilized in management’s methodology involved especially challenging and subjective auditor judgment. Therefore, we identified auditing the ACL modeling techniques and qualitative risk factors as a critical audit matter.

Our audit procedures to address this critical audit matter primarily included the following:

•Tested the operating effectiveness of controls over the implementation and application of the macroeconomic sensitive model and related factors including:

◦The Company’s ACL committee’s oversight and approval of management’s judgments and estimates utilized in the model for ACL on loans.

◦The Company’s ACL committee’s oversight and approval of management’s application of accounting policies, selection and implementation of model methodologies, and evaluation of qualitative risk adjustments determined by management.

◦Management’s controls over the completeness and accuracy of the data utilized in the macroeconomic sensitive model

◦Management’s controls over third-party model validation and testing of model performance.

•Substantively tested management’s process over the implementation and application of the macroeconomic sensitive model and related factors including:

◦Evaluated the reasonableness and appropriateness of the methodologies employed including, but not limited to, evaluating the soundness and appropriateness of the model’s significant assumptions and judgments.

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◦Utilized internal valuation services as specialists to assist in evaluating the development of the Company’s loss model used for CECL with specific emphasis on the development of the macroeconomic sensitive model.

◦Tested the completeness and accuracy of the data utilized in management’s CECL methodology to adjust baseline loss rates by loan segment, primarily relating to macroeconomic factors and qualitative risk factors.

◦Evaluated model sensitivity of different economic scenarios.

◦Evaluated the reliability and relevancy of data used as a basis for the qualitative risk factor adjustments and the reasonableness of management’s judgments used in the determination of the qualitative risk factor adjustment by loan segment and the resulting allocation to the allowance.

Goodwill Impairment Evaluation

As described in Note 1 “Description of Business, Basis of Presentation, Significant Accounting Policies and Recently Issued Accounting Pronouncements” and Note 8 “Goodwill and Other Intangible Assets” to the consolidated financial statements, the Company’s consolidated goodwill balance was $240.9 million at December 31, 2020, which is allocated to the Company’s single reporting unit. Goodwill is tested for impairment at the reporting unit at least annually, or more frequently if events or circumstances occur that indicate that it is more-likely-than not that the fair value of the reporting unit is less that it’s carrying value. Due to deteriorating financial market and economic conditions as a result of the COVID-19 pandemic, the Company determined a triggering event occurred prior to its annual assessment date and consequently engaged a third-party valuation specialist to assist management in performing a quantitative assessment of goodwill as of May 31, 2020. Based on the quantitative assessment, management estimated the fair value of the reporting unit by weighting results from the market approach and the income approach. Significant assumptions inherent in the valuation methodologies for goodwill were employed and included, but were not limited to, prospective financial information, growth rates, terminal value, discount rates, and comparable multiples from publicly traded companies in the financial institution industry. The evaluation of the methodology and the selection and weighting of these assumptions could have a significant impact on either the fair value of the reporting unit, or the determination of goodwill impairment, which could have a material effect on the Company’s financial results.

We identified auditing the Company’s May 31, 2020 goodwill impairment test as a critical audit matter. The principal considerations for this determination were the degree of auditor judgment in performing procedures over the significant assumptions, which included discount rate, growth rates, terminal value, prospective financial information, selection of relevant market comparable data, and weighting allocation to valuation methodologies, and the use of our internal valuation services as specialists due to its complexity.

Our audit procedures to address this critical audit matter primarily included the following:

•Tested the operating effectiveness of controls over the evaluation of goodwill impairment including controls addressing:

◦Management’s quarterly evaluation of potential triggering events regarding goodwill impairment.

◦Management’s evaluation of the methodology and significant assumptions utilized by third-party valuation specialist.

•Substantively tested management’s evaluation of goodwill impairment including:

◦Tested the completeness and accuracy of data utilized in the model.

◦Evaluated the reasonableness of management’s judgments regarding forecasted cash flows utilized in the methodology.

◦Utilized our internal valuation services as specialists to assist in evaluating the appropriateness of the valuation methodologies employed, significant assumptions, and the overall reasonableness of the fair value of the reporting unit.

◦Evaluated the sensitivity of the fair value to variable financial forecasting scenarios.

/s/ Crowe LLP

We have served as the Company's auditor since 2012.

Denver, Colorado

February 26, 2021

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

(In thousands, except shares)

ASSETS

Allowance for credit losses on loans (70,185) (36,171)

Other real estate owned — 841

Federal Home Loan Bank stock, at cost 6,661 6,377

LIABILITIES AND STOCKHOLDERS' EQUITY

Securities sold under agreement to repurchase 35,683 20,169

Stockholders’ equity:

Accumulated other comprehensive income, net 25,018 10,378

See accompanying Notes to Consolidated Financial Statements.

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

(In thousands, except per share amounts and shares outstanding)

Year Ended December 31,

INTEREST INCOME:

Nontaxable interest on investment securities 3,659 3,396 4,649

INTEREST EXPENSE:

NONINTEREST INCOME:

Gain on sale of investment securities, net 1,518 330 137

NONINTEREST EXPENSE:

Diluted earnings per share $ 1.29 $ 1.83 $ 1.49

Dividends declared per share $ 0.80 $ 0.84 $ 0.72

See accompanying Notes to Consolidated Financial Statements.

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(In thousands)

Year Ended December 31,

See accompanying Notes to Consolidated Financial Statements.

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

(In thousands, except per share amounts)

Cumulative effect from change in accounting policy (1) — — (5,615) — (5,615)

Exercise of stock options 8 122 — — 122

Stock-based compensation expense — 3,559 — — 3,559

Other comprehensive income, net of tax — — — 14,640 14,640

(1) Effective January 1, 2020, the Company adopted ASU 2016-13, Financial Instruments - Credit Losses.

Cumulative effect from change in accounting policy (1) — — (399) — (399)

Exercise of stock options 4 58 — — 58

Stock-based compensation expense — 3,231 — — 3,231

Other comprehensive income, net of tax — — — 17,833 17,833

(1) Effective January 1, 2019, the Company adopted ASU 2016-02, Leases.

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Cumulative effect from change in accounting policy (1) — — 93 (93) —

Stock-based compensation expense — 2,744 — — 2,744

Other comprehensive loss, net of tax — — — (6,064) (6,064)

(1) Effective January 1, 2018, the Company adopted ASU 2016-01, Recognition and Measurement of Financial Assets and Financial Liabilities.

See accompanying Notes to Consolidated Financial Statements.

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

Year Ended December 31,

Cash flows from operating activities:

Valuation adjustment on other real estate owned — 51 49

Valuation adjustment on interest rate swap 422 — —

(Gain) loss on sale of other real estate owned, net (179) 227 —

Gain on sale of mortgage loans held for sale, net (5,044) (2,424) (2,759)

Gain on sale of investment securities, net (1,518) (330) (137)

Gain on sale of assets held for sale (1,043) (169) (798)

Impairment of assets held for sale 630 102 75

Impairment of right of use asset 655 117 —

HFWA US Equity

HFWA · 10-K · period ended 2020-12-31

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

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

HFWA US Equity☆

HFWA · 10-K · period ended 2020-12-31

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

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

HFWA US Equity