As a banker, farmers often ask me, Where are interest rates headed? Increasingly, they are also asking an important second question: What can I do to manage the risks to my operation from interest rate movements?
The simple response to where interest rates are going is: They will change. While that is not as concrete an answer as we would like, it does have the merit of most likely being true.
Current interest rates are near historic lows. Four years ago the prime rate was over six per cent. That is double today s prime rate. While we are not making any predictions about where interest rates might head, it is good practice to consider how rising rates might affect your farm operation.
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For the unprepared, rising interest rates can present challenges. As interest obligations increase, cash flow tightens, potentially affecting other aspects of your farm business. Higher interest costs can flow into your operating loan, increasing the balance and reducing the amount of short-term financing available for working capital. This can then cause farms to stretch terms with suppliers and it can erode their ability to service debt.
Over time, these issues can affect your farm s ability to operate efficiently. The following strategies, however, will help you plan for possible increases in interest rates.
1. Start with a stress test
While interest rate fluctuations are beyond our control, planning and preparing for a rate increase constitutes sound management. First, before you develop a strategy to deal with rising rates, it s best to look at how rising rates could affect your farm.
To do this, start with a simple stress test. A stress test involves applying an anticipated higher interest rate to your debts to estimate the increase to your payments. A spreadsheet makes this easy. Consider the following example:
” While different types of loans usually have different interest rates, for simplicity in this example all loans use the same interest rate.
As is evident, a small interest rate change of one per cent on this farm will increase interest payments by 20 per cent.
Once you have actual numbers to work with, you can better determine your farm s ability to absorb rising rates. Compare the increased payments to your cash flow projections. Some farms can bear more interest rate fluctuations than others. It all depends on your business model and cash flow.
2. Consider fixed rates and laddering
If you feel interest rate risk is something you want to mitigate, there are several strategies to consider. Where possible, fixing your interest rates can be effective. A fixed rate loan locks the interest rate for a period. This eliminates exposure to interest rate fluctuations for the duration of the selected term.
You can enhance this strategy by splitting your loan into several segments with different lengths of term. For example, split a $300,000 equipment loan into three separate $100,000 segments with terms of one, three and five years respectively. Commonly called laddering, this strategy serves as a further hedge against potential rising rates. When the respective terms expire, only a portion of your debt is exposed to the prevailing rates.
3. Manage rates on operating loans
While fixed rate strategies are more common with term-debt, in volatile interest rate environments you can also fix rates for operating loans. If you carry a balance on your operating loan for 30 days or longer, fixed rates on your operating loan can help limit exposure to rising rates by locking in the rate for a portion of the balance. You can choose a term that corresponds with your expected cash flow. When the term expires, the balance simply shifts back to the floating rate operating loan.
4. Assess floating rate term loans
Even with floating rates, which fluctuate with changes in the prime rate, you can still reduce the risk associated with higher interest rates. By increasing the size of your regular payments, your principal outstanding will reduce more quickly. This produces two benefits. First it prepares your farm for higher payments should rates increase, and second it reduces the amount of principal that would be subject to higher rates.
Another strategy is to make lump sum payments when cash flow permits. While this does not prepare your farm for higher regular payments, it does reduce the principal exposed when rates increase.
Every situation is unique, but by stress testing your balance sheet and determining your tolerance for rising rates, you can then decide your interest rate strategy. Whether you choose to fix rates, ladder your terms, increase your regular payments, or make lump sum payments, the exercise will help prepare you and your farm for rising interest rates.
While interest rates have been low for some time, you only have to look back to the early 80s to realize that things can change rather dramatically. If you are concerned about rising interest rates and the effects they may have on your farm, speak with your advisers, including your banker, on what strategies may be right for you.CG
Karl Mclaren is an agricultural banker at BMO Bank of Montreal. He has an agricultural business degree from the University of Guelph and previously operated a dairy farm in Eastern Ontario.
