Most institutions now use financial models to quantify risk, which in turn determines the premium or discount to the interest rate.
Charlie Chisler and his sister in law Terry Tightwad found themselves arguing over interest rates last week and who had gotten the better deal. Charlie operates a 3,500-acre grain farm and Terry operates a hog operation. They both needed to deal with local account manager Hans Inmapocket to arrange financing for the purchase of their uncle’s land. They were each to purchase a half section of land and were quite surprised to find out they had been offered different five-year interest rates. Charlie does a large volume of investing and finance business with the financial institution and was ticked right off when he found out Terry’s rate. Charlie and Terry both pride themselves on being excellent negotiators and Charlie wanted to find out why he missed out on the best deal. In our annual meeting with Charlie, we explained to him the background of risk related interest rates — a practice commonly now used by most financial institutions.
Most institutions now use financial models to quantify risk, which in turn determines the premium or discount to the interest rate. The model generally is calculated based on a number of different factors. Some of these factors are within our control and some of these factors cannot be manipulated. If you are not aware of these factors, then you, like Charlie, will have a pretty tough time cracking a deal that you will be proud of. There are two main categories of factors affecting your interest rate. Category one is risk. Category two is cost for the financial institution to put the loan on the books.
KEY FACTORS FOR RISK MODELS
Past credit history with that particular institution. A zebra never changes his stripes.
Enterprise. At any given time, the risk appetite of a particular lender is affected by industry conditions. For example, the stability of the supply managed dairy and poultry industries have resulted in lenders providing this industry with discounted rates.
Leverage. The amount of debt as a per cent of your equity indicates your ability to withstand adverse conditions. High equity operations that do not have much borrowed have options in terms of refinancing that a highly leveraged operation would not have. Often the leverage calculation is completed on the borrowing entity, which may or may not include shareholder equity. Some institutions will take shareholder equity into account if a personal guarantee is provided.
Security margin. The value of the security in relation to the outstanding loan amount is a direct measure of risk to the lender. The more security provided, the lower the risk. That translates into a better rate. In addition, the type of security often impacts the rate. That’s why a mortgage loan rate can be different from machinery or livestock.
Commercial credit rating. Your Equifax report or Dun and Bradstreet report is generally entered and factored in. This rating is a measure of how responsibly you’ve historically managed your trade credit.
Repayment. How many dollars you have available to make every dollar of payments is taken into account. Obviously the more dollars the better.
Amortization. How long is the repayment period? The longer the loan, the higher the risk.
Payment frequency. Monthly payments are considered less risky than annual payments. The creditor will notice repayment problems sooner with monthly payments and remedies can be applied before a farm misses an entire year of payments.
KEY FACTORS FOR COST MODELS
Exposure. The amount of debt you owe to an institution will affect the cost in making you another loan. This is no different from having more acres for your combine!
Type of loan. Process will differ for different types of loans. Some loans can be put on the books for very little cost and other loans are very specialized and expensive for the institution.
Interest term. A loan that is not locked in can be paid out at any time and the overhead cost of that loan has to be built into the interest rate. The longer the interest term generally the higher the interest rate as the borrowing cost for the institution is higher.
Charlie Chisler now feels better prepared to meet up with his
banker Hans Inmapocket. Rather than just push for a lower rate, Charlie can use his new knowledge of the risks and costs that affect loan rates to work the models and earn a lower rate.
Andrew DeRuyck and Mark Sloane manage two farming operations in Southern Manitoba and are partners in Right Choice Management Consulting. With over 25 years of cumulative experience, they offer support in farm management, financial management, strategic planning, and mediation services. They can be reached at [email protected]and [email protected]or 204-825-7392 or 204-825-8443.