I have received many calls this winter seeking advice on whether to lock in interest rates. Here are some issues and areas to consider in helping you make those decisions.
First, it is a good time to consider locking in rates after 12 rate drops by the Federal Reserve Board during 2001. However, keep in mind the Fed only determines short-term rates. It has no immediate impact on long-term rates.
The bond market impacts long-term rates and inflation expectations have a big influence on bond prices. Long-term rates have not dropped as fast as short-term rates and have even risen since mid-November 2001. This tells me there is increasing uncertainty about inflation.
Every farmer has a different financial and psychological ability to bear interest rate risk. But if you can stand the ups and downs of the interest rate roller coaster, you will pay fewer dollars of interest over a farming career by using variable rate notes.
That's because variable rate notes are funded by short-term money instruments. In about 16 of 20 years, the yield curve shows short-term money is less costly than longer-term money. However, most farmers who borrow substantial amounts of money can't or don't care to take that risk. That's where locking in rates makes good sense.
Let's look at short-term loans. Locking in your short-term rates may not be as critical in 2002 as in 2003 and beyond. But, it depends on the amount you have borrowed, your working capital position, profitability margin and overall debt structure. Some people just sleep better at night with fixed rates. If that's the case, lock in your rate.
In the last 12 weeks, I've talked with many of our clients who refinanced their operating lines. Rates have varied from 4.25% to 8.25%. That's a huge variance. So if you're on the upper end, you need to talk again with your lender. Some lenders see low-cost, short-term funds as an opportunity to widen their margins — at your expense.
Let's look at intermediate and long-term loans. Fixing rates is even more important on intermediate and long-term rate decisions. The probability of rates going much lower is less than the risk of them going higher.
Locking in single digit rates is never a poor decision. It's an opportunity to lock in your fixed costs on purchasing decisions. Again, simple logic says that over the last 30 years rates have been a lot higher and could return.
If you do lock in intermediate and long-term rates, look for a loan product that does not have a prepayment restriction. If rates do drop further, you can then roll down with them for a reasonable cost.
Generally, if you can recoup the costs of rolling down the rate with six months of interest savings, do it. For example, if the lender charges 0.5% to roll down 1%, it's a good decision. You're about even for six months and ahead after that.
Some lenders offer loan products that carry lower fixed rates but have prepayment restrictions for only three or five years. That may be a good decision, especially if you're carrying a lot of debt and most likely will not be in a position to pay the loan off in that period.
Recently, one of our best clients purchased his first farm. He decided on a 25-year, 7.2% fixed-rate loan for the first mortgage; and that the portion of the down payment that will be secured with machinery should stay variable. He has strong earnings history and potential, and he'll likely have the intermediate note paid off quickly — a good decision.
Moe Russell is president of Russell Consulting Group, Panora, IA. Russell previously spent 26 years with Farm Credit Services as a division president. For more risk management tips, check his Web site (www.russellconsulting.net) or call toll-free 877-333-6135.