Now that interest rates have increased, many producers want to know whether they should fix interest rates on their loans or continue on with a variable rate. Here are five considerations when making that choice for your farm loan.
First, interest rate trajectory must be considered. Specifically, that is how fast the U.S. Federal Reserve will increase interest rates. Watch the updated data on unemployment as well as inflation. If unemployment drops below 5 percent and inflation increases above 2.5 percent, the interest rate trajectory could ascend quite quickly.
Second, interest rate decisions depend on the individual business and more importantly, the preference of those individuals that sign “on the dotted line.” Borrowers must examine the loan agreement and determine what percentage of debt is on fixed or variable rates to measure vulnerability.
Third, develop a cash flow projection and ascertain how interest rate changes will affect projected positive or negative profit margins. Can your business stand a 2-3 percent rate hike or would an increase influence your bottom line? If the net margin is severely depleted by a 1 percent rate shock increase, you may consider switching all your variable rate loans over to fixed rates.
Fourth, make sure you meet expenses and avoid spending revenues on capital assets such as, machinery or equipment. Discipline and control are crucial; particularly on operating money. A vulnerable area for interest rate shocks will be operating money, which is historically on a variable rate. Some producers have already re-financed operating debt over to a five to seven year fixed rate note. The key here is to use the money solely for operating expenses.
Fifth and finally, can you sleep at night? This is the ultimate test on whether you are comfortable with your rate decision. In addition, it is always wise to make sure decisions are consistent with your spouse and partners before finalizing any agreement.
Most producers make numerous decisions each day, but remember, it is normally several different, small decisions that make a difference; not one big decision. In an environment of margin compression, decisions on rates will become very important as businesses navigate the coming economic reset years.