Overnight rate changes could weigh on farm financing: FCC

Farmers and agribusinesses in Canada may want to consider a review of their financing strategies ahead of a potential rise in interest rates, Farm Credit Canada recommends.

The federal ag financing agency made its recommendation in a release Monday “in light of recent Bank of Canada statements.”

Canada’s central bank on May 31 said it would maintain its target for its key overnight rate at one per cent, with the bank rate at 1-1/4 per cent and deposit rate at 3/4 per cent.

However, the bank is “closely monitoring inflationary pressures for signs that might warrant increases in the overnight rate,” FCC said Monday.

Underlying inflation is now “relatively subdued,” the Bank of Canada said May 31, but noted “high energy prices and changes in provincial indirect taxes will keep total CPI (consumer price index) inflation above three per cent in the short term.”

Total CPI inflation is expected to converge with core inflation at two per cent by mid-2012, the central bank said, as “excess supply in the economy is gradually absorbed, labour compensation growth stays modest, productivity recovers and inflation expectations remain well-anchored.”

“Key cost”

The central bank’s overnight target rate influences variable mortgage rates, with the prime rate typically changing by the same amount as the overnight rate.

The Bank of Canada raised rates three times in 2010 but has made no changes since last September, FCC noted.

“Because mortgage costs are often a key cost in a farming operation, one of the most frequent questions we hear is: ‘Should I go with a fixed rate or a variable-rate mortgage?'” Don Stevens, FCC’s vice-president of treasury, said in the release. “The answer is that it depends.”

From 2005 to 2007, for instance, when the Bank of Canada was increasing the overnight target rate, FCC saw greater demand for fixed-rate mortgages and saw conversions from variable to fixed rate, he said.

When interest rates are low, variable rate loans are the popular choice, with about 80 per cent of new FCC loans to farmers and agribusinesses made using the variable rate in the past year. Variable-rate loans now represent about two-thirds of FCC’s portfolio.

“No one knows what the Bank of Canada will do. However, if you examine past trends to keep inflation or inflation expectations in check, we expect that interest rates will be higher in 2012 than they are now,” FCC senior economist Jean-Philippe Gervais said in the release.

“A consensus among leading market economists is that the overnight rate should increase by 175 basis points over the next 18 months,” he said. “If this prediction is accurate, it should imply a 4.75 per cent prime rate by Dec. 31, 2012.”

Prime rate is now three per cent and the 10-year average for prime is 4.4 per cent, he said.

“Rate risk”

Fixed rates offer protection against rising rates over the length of a fixed-rate interest term, and make it easier for a business to calculate potential profits and losses, FCC said. However, fixed mortgage interest rates are generally higher than variable and also involve break fees or prepayment penalties if a loan is paid off before the end of a term.

Variable-rate mortgage owners, meanwhile, pay less most of the time if interest rates are falling, and are also able to convert to fixed rates without penalties. However, FCC said, they also run the risk of higher rates if prime increases.

Stevens stopped short of saying every farmer or agribusiness should lock in now, but said “if a farmer is already carrying significant financial risk, then reducing interest rate risk may be a smart strategy.

“Although everyone wants to save money, sometimes it’s prudent to proactively take risk off the table.”

One method to reduce interest rate risk is to have more than one mortgage, with different terms and a combination of fixed and variable rates, which means that the borrower’s debt reprices at different times, FCC suggested.

“Of course, this has to be weighed against the complexity of managing multiple mortgage terms.”

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