Looking for a loan? Add in interest rate risk when deciding to borrow

With Canada enjoying some of the lowest borrowing costs on record, it might be time to consider that expansion, but how do you avoid the landmines if interest rate shifts appear on the horizon?

Terry Betker, CEO and president of Backswath Management Inc., advises farmers on managing interest rate risk.

Working on your farm management skills is like exercising… it pays big benefits, but it’s easy to push it off for another day. Only one-third of producers use business advisers or risk management tools, and fewer still do HR, succession, or strategic planning.

To help make your farm more profitable (and your life more enjoyable), this ongoing series from Glacier FarmMedia combines expert advice with insights from farmers who have gone down this road.

For borrowers in Canada over the last decade, low interest has been par for the course.

In May 2007, the Bank of Canada’s overnight rate was 4.25 per cent, a number that plummeted to one per cent by February 2009 and has yet to rise above one per cent since. In 2015, the rate fell twice, finally reaching its current 0.5 per cent.

For farmers looking to expand, the lower interest and cheaper loans that came with it are good news and Canadian producers have taken advantage.

By 2015, farm debt had risen to $91.8 billion, up from $84.6 billion the year before, according to Statistics Canada.

J.P. Gervais, chief agriculture economist for Farm Credit Canada (FCC), has said low interest is at least partially responsible for the jump in farm debt, although farm income is a larger contributing factor, in his view.

“Almost year after year, we’re breaking records, growing income, growing farm income and at the same time we’re making investments, being more productive. That has been growing farm debts, which is obviously encouraged as well by low interest rates,” he said.

Realized farm income jumped 7.6 per cent in 2016, the third consecutive year of net increase, Statistics Canada says. At the same time, asset appreciation has outstripped both debt and income increases, according to the 2016-17 farm debt and asset outlook from FCC. The organization reported that asset values increased 155.1 per cent from 2001 to 2015, above the 125.8 per cent increase in debt and 85.2 per cent increase in farm cash income.

The same report linked soaring costs of farmland and buildings with increases in farm debt. While debt increased 125.8 per cent from 2001 to 2015, farmland and building values appreciated 211.1 per cent. Farmland appreciation has also outpaced farm revenue nationwide over the last five years, the report said.

Managing the risk

As with any loan, borrowing money for the farm comes with a risk that interest rates could rise.

Borrowers perform a delicate balancing act, trading between the risk of floating rates — lower, but open to upwards pressure — with more secure, but expensive, fixed rates.

The Bank of Canada’s interest rate is expected to remain low, although at least one economist from the Bank of Montreal has told the CBC that rates may increase by April of next year. It’s important to remember the central rate is not the only thing that determines the rates you pay.

In particular, Gervais said, interest rates may be impacted by financial policy in the United States. In March 2017, the U.S. Federal Reserve increased key interest by 25 basis points.

“What customers need to understand is the rate that they pay is a function of the rate that the financial institution itself borrows some money (at) to lend it back to producers,” Gervais said. “If interest rates in the financial market — and I’m talking about government bonds, corporate bonds — and if all of these interest rates in the U.S. are moving up, it is likely that at one point it will be moving up as well in Canada.”

Terry Betker, CEO and president of consulting firm Backswath Management Inc., says conversations with his customers often start with the reason behind their loan before moving into what terms and conditions the operator can afford.

“The advice that I give farmers is to look at their debt servicing ability, the term — how long they’re committed to the payments — the impact on their ability to generate cash flow and then, in a worst-case scenario, if they have to restructure, do they have the ability to do it?” Betker said.

Perhaps most importantly, Betker said, a well-managed loan should be flexible and producers should leave room for possible interest shocks or unexpected drops in income.

For those who are risk averse, a two-to-one ratio of earning ability for every dollar of payments is ideal, but often unattainable on the farm, Betker said. Most producers instead set a tolerance between $1.25 and $1.50 to $1.

“This depends a little bit on a function of cash flow,” Betker said. “A farm that’s in supply management, that has more stable cash flow, then they can, I think, afford to be a little tighter on their debt servicing. Farms that have more variability in income, like a grain farmer for example or a livestock cow-calf operation, perhaps they would like to get closer to 1-1/2 to one to be really more comfortable with the risk associated with borrowing the money.”

Borrowers through FCC, meanwhile, might be asked if they could afford products one rung higher than their preferred option.

“If the answer is yes, then we’re a lot more comfortable making that deal,” Gervais said, adding that a one per cent interest rate variance is generally considered “comfortable.”

Risk tolerance will be unique to each operation, Gervais said.

“If you’re a mature business that’s been established — you’re not looking to expand too much and you’ve got lots of equity — maybe you can put a little more risk on the table and say, hey, I’m OK to let my rates float and if they go up, I can live with that,” he said. “If I’m a young entrepreneur and just got into the industry and made a lot of investment decisions, maybe I like to have the security of knowing that ‘this’ is going to be my payment for the next five years, next seven years.”

Betker also pointed to farm size relative to the size of the loan. A large farm will have the ability to build more flexibility than a smaller farm taking out a similar-size loan, he said, as the loan to the bigger farm would be a smaller proportion of overall farm value. A large loan, meanwhile, will often open doors to multiple maturation dates and prepay options, allowing producers to further customize rates and terms.

Mixing and matching

Should a farmer opt for a variable rate, they may save substantially, but may also face a financial hit if those interest rates rise. A farmer opting for the fixed rate, meanwhile, may end up losing out if the lower variable rate does not rise.

In most cases, producers with a floating rate may later lock it in, should interest forecasts turn stormy, Betker said, but pointed out that the process of locking in a rate comes with its own perils.

“Understand that the spread between floating rates or variable rates and fixed rates widens before the floating rate goes up,” Betker said. “Lenders’ risk is not in the short-term money to interest rate, it’s in the long-term money. They don’t want to get on the wrong side of long-term interest rates, so if a lending institution thinks that there might be some risk to interest rates increasing, they’ll increase their long-term rates before they increase their variable rates.”

With this in mind, a farmer looking to lock in an interest rate might suddenly find long-term rates, which were only slightly higher at the time of taking out the loan, have outpaced the short-term rate in the interim.

For farmers who are risk averse but hope to take advantage of lower, but riskier, floating rates, Betker suggested a regimen of self-disciplined saving. Rather than spending the money saved by risking a floating rate, funds could be set aside as contingency in case of interest increases or used to pay back principal.

The “ultimate mitigation to interest rate increase” however, according to Betker, is the ability to term out an agreement should the worst occur and the loan becomes unaffordable.

“Do you have the ability to restructure the debt in your balance street?” Betker said. “Principal is principal, but if interest rates go up and you can’t generate the cash flow in the business to make the payments as they are currently structured on a farm, what do you do? Well, you could sell assets; you could try and be more efficient, but generally the action taken would be to term out the debt, to extend the payments.”

Such an option would require assets to put against the new deal, Betker said. For some highly leveraged farms, that ability to manage a worst-case scenario may be out of reach.

What not to do

Borrowing money may foster a desire to pay it back as quickly as possible, but overaggressive repayment is among the top mistakes that Betker has seen producers make, along with financing large purchases through operating loans or automatically using extra funds to pay off only high-interest loans. Instead, he suggested, producers should prioritize loans with the highest combined interest and principal.

“I think they could do a better job of putting some flexibility into how the loans are termed out and align their repayment with their ability to generate cash flow,” he said.

Gervais, meanwhile, has linked success with a firm grasp of the link between a dollar of debt and expected monetary return from an investment.

Overall, he said, farm financial conditions have “evolved the right way.”

FCC’s 2016-17 outlook identified possible challenges as projected farm income and land appreciation flattens, and acknowledged that farmland values were outstripping crop receipts. “Financial risks remain manageable as the outlook for interest rates and net cash income are supportive of the balance sheet,” the report read. “It remains prudent for agricultural operations to be flexible enough to amend business plans if the outlook for borrowing costs and/or profitability moves in a different direction.”

Should interest rates rise, Gervais expects both asset values and debt to slow down, although overall impact on farm debt would be hard to gauge.

About the author


Alexis Stockford

Alexis Stockford is a journalist and photographer with the Manitoba Co-operator. She previously reported with the Morden Times and was news editor of  campus newspaper, The Omega, at Thompson Rivers University in Kamloops, BC. She grew up on a mixed farm near Miami, Man.



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