Understanding the terms of your loan is critical
After multiple years of low commodity prices, the agricultural lending community is bracing itself for a busy year. There are a lot of folks with carryover debt that needs to be refinanced. If you are one of those producers, or if you are purchasing a farm, be sure you brush up on a few things before you sign on the dotted line for that new mortgage.
What’s a Fixed Rate loan?
• The rate stays the same for the life of the loan.
• The payment remains the same over the life of the loan.
• The rate is generally higher than an adjustable rate, but cash flow is easier to manage.
• This is a good option if you plan to keep the loan for a long time.
What’s an Adjustable Rate loan?
• The rate will change at pre-determined intervals over the life of the loan.
• The payment will go up or down based on the interest rate environment at the time it adjusts.
• The rate is generally lower than a fixed rate loan, which will help your cash flow while times are lean.
• This is a good option if you plan to make changes to your operation in the next couple of years.
So which do you choose? What are your plans for the next five to 10 years:
• Is a construction project in your future that will require financing?
• Do any of the partners plan to exit the operation anytime soon?
• Do you have plans to buy another farm that will require using the equity in your existing farm?
If you answered “yes” to any of these questions, you will more than likely need to refinance the farm in the near future. In that case, an adjustable rate may be your best option.
If you have no plans to make any big changes to the operation, a fixed rate is probably your best option, given our current economic situation.
There are also a multitude of “hybrid” loan products. These include 10/1, 7/1, 5/1 and 3/1 Adjustable-rate mortgage (ARM) products. The first number is the number of years that the rate is fixed. The second number is the number of years after the initial fixed rate in which the rate will adjust. For example, if you have a 10/1 ARM loan, the first 10 years will be at a fixed rate. After that 10-year period, the rate will adjust every year thereafter.
Whichever option you choose, be sure you know the amount of time the rate will be fixed and how often it will adjust. Make sure you get all of that information in writing before closing the loan.
Adjustable Rate Index
If you elect to go with the adjustable rate option, it is important to know to what the rate will also be indexed. Lenders will typically adjust the rate to a spread over a certain index. There are a lot of lending institutions that use the prime lending rate. The prime lending rate is typically shown on the promissory note as “Wall Street Journal Prime + XX.” However, not all lending institutions index to prime. Be sure you know to what your rate will be indexed and the spread over the index.
Prepayment Penalty
In the 1990s, it was common for loans to have prepayment penalties. During this time, it wasn’t uncommon to see a loan with the penalty as high as 25 to 30 percent of the principal balance. Most of these types of loans have faded away since rates have been low, but be cautious – some are still out there. Ask your lender if the loan has a penalty clause for early payment of principal.
Balloon Payments
If the term on the loan doesn’t match the amortization, you will have a balloon payment. The term of the loan tells you when the loan will mature, but the amortization tells you how your payment will be structured.
Make your lender explain the loan terms in words you understand. Don’t get so caught up in the need to get your loan closed that you get into a situation that doesn’t work for you.
Kathy Daily is the senior vice president of First Financial Bank’s Farm and Ranch Division. She has been an agricultural lender for more than 25 years.
