It’s no secret. In 2016, many farmers’ balance sheets will look sharply different from those seen in the last 10 years. During that super-cycle of strong farm earnings, risks taken were often rewarded and decisions to leverage financial statements well-warranted. Conditions were ideal to bring family members back into the farming operation and many increased their net worth and working capital, allowing farmers to prepare for this new reality setting in. Commodity prices have fallen while input costs, land prices, and cash rents remain high – creating tight margins, to say the least.
In today’s reality, experts predict a rise in debt levels for producers, increasing the importance of debt monitoring and the level of trust between a borrower and a lender. Farmers who find ways to drive down their cost per unit of production and manage their debt closely can protect against loss and position themselves for continued success.
Cutting Costs Beyond Inputs
As producers aim to keep expected net farm income and expenses in line, they can also look for ways to lower their cost of financing. Farmers should review their exposure to rising interest rates and determine whether fixed rate financing alternatives for portions of their debt may benefit them over the long haul. Variable rates continue to be low. When a farmer chooses a variable rate, he or she accepts the risk that interest rates could rise during the term of the loan. This could result in even higher payments at a time when farmers may be least able to afford them.
The Federal Reserve raised its benchmark interest rate by a quarter of a percentage point on December 16, 2015, the first increase in 9 years and there is speculation that rates will rise gradually over time. Depending on the maturity of their debts, a borrower could realize a cost savings by locking in today’s low fixed rate and therefore limit interest rate risk over the term of their debt.
We are already seeing farmers in our 60-county territory in Illinois moving in this direction. As of December 31, 2015, approximately 50 percent of Farm Credit Illinois’ real estate portfolio was priced on a fixed interest rate guaranteed for 10 years or longer. About 30 percent was on an adjustable interest rate (fixed for a specified period of time that then adjusts) of one to nine years, and the remaining 20 percent was priced on a variable rate.
Although the cost of borrowing at adjustable or fixed rates will initially be higher than borrowing at current variable rates, adjustable and fixed rates offer several advantages. Some factors to consider when deciding how much debt to keep in variable rate programs and how much to lock into adjustable or fixed programs before rates start to rise include are:
- Variable Interest Rate Loans Require Less Cash Flow to Service the Debt– Increased cash flow is important to farmers, which makes the variable rate attractive while it remains low. And if the length of time a farmer plans to carry the debt is relatively short, then a variable program may be a good solution. However, variable rates can adjust at any time. So if interest rates rise, a producer who locked in a fixed rate for a portion of their debt may benefit from significantly lower interest costs over the long term. This would be especially true if the Federal Reserve is forced to raise rates more aggressively due to an unexpected or unwanted increase in inflation.
- Adjustable Rate Loans Allow Farmers To Fix a Rate for a Shorter Term Before Adjusting – Farmers often consider this option when they don’t want to pay the premium for a long term fixed rate, but want some protection for a certain amount of time. For example, they may want to fix a rate on a debt for only five years because they intend to pay it off at the end of that term.
- Fixed Rates Offer Reduced Risk While Carrying Debt Longer than 10 Years – With fixed rate loans, borrowers know what their payments will be for the full term of the debt. This eliminates the risk of higher debt service payments in the later years of the loan. The certainty of interest costs over the term of the borrowing may be especially welcome to agricultural producers as they closely monitor their expenses
- A Combination Approach to Managing Debt Offers the Best Solution – Many farmers are very astute at managing their finances and often use a blended rate approach for their portfolio of loans by using all three programs. The accompanying video interview with a Decatur, Illinois loan officer illustrates how this works.
It’s also important for farmers to check with their lender on options to reduce their rate without refinancing a loan in the event that rates decline. This would give them the benefit of a lower rate without again paying closing and appraisal costs.
Net farm income is forecasted to decline in 2016 before leveling off. Farmers who evaluate their financial and risk management strategies will have a substantive payoff in this economic environment. Managing interest rate risk is just one of the tools they can use in adjusting to the new economic environment.
Steve Carson is Senior Vice President of Credit at Farm Credit Illinois. He was raised on a livestock and grain farm near Monroe City, Missouri. He earned a bachelor of science degree in Agriculture from the University of Missouri. Send your comments or questions to scarson@farmcreditIL.com.