How to best prepare for future changes
The last two years have been unique to say the least. As you look forward to 2022, you may be concerned about the current economy, inflation and debt alongside the continuing pandemic. These issues are probably leading you to wonder how you can best prepare your operation for future changes.
The Federal Reserve sets interest rates. They do so in a strategic manner to assist the economy. With the uncertainty of today, now is a good time to consider how interest rates can affect your loans and the long-term viability of your operation.
Fixed, adjustable, and variable are different types of interest rates. Understanding the differences in the types of interest rates and what that can mean to your farm during unsettled times is an important management strategy.
A fixed interest rate is the most easily understood. If you have a 20-year real estate loan with a fixed rate, you will pay that interest rate for the life of the loan. Fixed rates provide the least amount of risk but may be higher than the other interest rate options. Currently, rates are still low. It could make sense to switch to fixed rates if you anticipate rates increasing.
An adjustable interest rate is as it sounds, a rate that will adjust over time. Often an adjustable-rate loan provides an established rate for a specific amount of time. After that time period, the pricing matures, and the new interest rate is based on the current market. For example, a 20-year real estate loan with a five-year adjustable rate means that the interest rate is locked in for the first five years and after that it will be adjusted. Some organizations may refer to this type of rate product as a fixed rate, calling the rate in the example a five-year fixed rate. A true fixed rate loan is fixed for the life of the loan.
It is important to fully understand the loan terms associated with adjustable rates and the difference between the amortization period and the maturity date of the note. Ask your lender how many years the interest is locked and have them explain the specific terms and renegotiation process. If you have adjustable rates, it is time to consider what increased rates over the life of the loan may look like for your operation. Develop what-if scenarios to see what your operation can handle.
The third type of rate is a variable interest rate. This rate is always changing because it is never locked in. These rates are usually tied to a margin set above a specific index such as the prime rate, discount rate, treasury rate or a rate that is established by the lender. Whenever the identified index moves, the borrower’s rate moves. Some variable rates establish a floor. This is a minimum rate that the variable rate will never fall below. If you have a five-year variable rate machinery loan with a floor of 2.5 percent, your rate will never go below 2.5 percent. Again, it may benefit your bottom line to look at what increased variable rates will do to your operation. If you are considering purchases tied to variable rates, be sure to talk with your lender and revise your business plan as needed.
Finally, as you consider your options you should analyze the volatility of the current financial environment and historical trends. Your risk tolerance, cash flow and size of debt are also factors to consider. Determine if your cash flow is strong enough to absorb a 2-3 percent change and still be viable. Look at the size of the debt. The larger the debt the more risk to the cash flow when the rate moves.
As you update your business plan for 2022 and consider what-if scenarios, you will want to work closely with your lender.
Scott Schaumburg, is a FCS Financial Vice President, West Plains, Mo. He can be reached at 417-256-2298
