Imagine a situation where your bank or credit union wants to raise the interest rate on your operating line this year. For some it won’t take much imagining because it already happened recently or in years past. If your interest rate has been the same “Prime plus 1” or something similar for the past several years, why did your lender decide to raise it this year? Especially this year when you harvested all that tough, lower value grain in November, cash flow is tight and income will likely be down from your cattle enterprise as well. Well, the higher interest rate and the tough year financially are likely related. In this article I will explain that relationship, help you understand it and finish up with a tip or two on how to manage it.
The simple explanation for the rise in rates is that interest rates are established based on the lender’s perceived risk — for the loan and the borrower. If you read my last article in Grainews (page 40, February 22 issue) you will recall I talked about two types of risk that lenders analyze: the risk of loan default and the risk of loss in the event of default. I also gave you an introduction to some underlying credit concepts and a basic framework used by most lenders to analyze those risks.
Most lenders use one or more risk analysis software tools to help them in this task. For farmers borrowing smaller amounts (and the definition of “smaller” varies somewhat across the financial institutions) the process is likely pretty automated with the computer program producing a “risk rating” or “score” with minimal involvement and interpretation from the loans officer or account manager. Information from your financial statements or tax returns along with credit bureau reports provide most of the required input for this analysis.
For larger and more complex borrowing situations, accountant prepared financial statements are usually required and the account manager, credit specialist and/or risk manager does an in depth analysis and interpretation of the farm’s financial position and results. In these situations financial projections for the next year or more may also be required to add to the analysis. There will also be more subjective interpretation of such things as your management strengths and weaknesses and character. The result is similar regardless of the amount borrowed. The lender determines a risk rating or score.
RISK DETERMINES RATE
The risk rating or score for any loan application determines your interest rate. Embedded in the software and underlying the calculation of the risk rating is a great deal of historical loan default and loss data that has been analyzed and interpreted by your financial institution. Key factors contributing to default and loss are built into their risk rating calculations.
The type of loan or lending product determines the base interest rates, to which a risk adjustment is applied for each borrower. Consider for a moment the highest interest rate lending product offered by financial institutions. It is, of course, the credit card. The reason credit cards have the highest rate is because they are very easy to obtain and are basically unsecured. Remember my earlier point that “interest rates are established based on the lender’s perceived risk of the loan.” That tells us that financial institutions perceive credit cards as a pretty high risk type of lending and they compensate for that higher risk and occurrence of default and loss by charging a higher interest rate. And since there is such a simple application process and this is a “mass product,” there is rarely any difference in rate based on the actual borrower risk.
Real estate mortgages are at the other end of the scale and usually have the lowest rates because there is more analysis done (whether it is a farm, business or home mortgage) to ensure repayment ability. Also it is longer term commitment and more importantly the property that is the security is not going anywhere. In other words, there is usually a known stable market for property and our land titles based mortgage registration systems ensure the security value can be realized by the lender.
Between these two extremes we have operating loans secured by growing crops, inventory, accounts receivable and equipment and livestock loans secured by the equipment and livestock. Because these assets are more liquid and mobile you can see that the lender’s risk of getting the loan repaid if the borrower defaults does vary depending on the type of loan.
WHAT TO DO IF YOUR RATES RISE
If your lender is raising your interest rates, my advice is to determine the underlying reason. You need to know if the reason is a weakening of your farm’s financial position, or perhaps even a sign of growing concern by the lender of your management ability to produce sustainable good results. In other words, find out if the lender has determined that your “risk rating” has changed and if it has, what were the factors that caused the change?
My tip here is to simply ask questions to determine the reasons your interest rate is going up. My hope is that the information I have given you in this article will help you ask the right questions to get the answers you need. In my view a good lender would be more than happy to explain this to you.
In my experience, the cause for a higher interest rate in the situation I’ve described is some change in the financial position of the farm. If there has been some reduced returns, likely a key ratio such as your Current Ratio has changed enough to raise your overall risk rating. (Editor: For more on Current Ratio, see Andrew DeRuyck and Mark Sloane’s column on page 16 of the March 1 Grainews.) My point is if you know the cause you may be able to manage your financial position in a way that improves the ratio, which in turn will improve your risk rating and result in a lower interest rate.
This may or may not be some-
thing that you can accomplish immediately. For example a poor or inverted Current Ratio may be improved very quickly by some debt re-structuring. However depending on the problem, it may take a year or even two or more to improve your risk rating. But if you are serious about wanting lower interest rates, you need to understand this stuff and make appropriate management decisions as a result.
MAYBE ALL RA TES ARE GOING UP
The higher interest rate may in fact have nothing to do with you directly. Maybe there has been a general shift upward of rates to all borrowers by your financial institution based on either internal or external factors. For example, your financial institution may have changed its view of the overall risk of lending to agriculture or your sector of agriculture. (Remember the “C” called Conditions in my February 22 article.) Or its treasury department may have adjusted the cost of funds for term loans, as an example, based on financial market or global credit market changes that have nothing to do with agriculture.
The point is you need ask your lender for the reasons because only then can you understand what is going on and, if possible, take proactive actions to manage the situation. These actions might be getting your financial ratios more in line with what the lender is looking for or perhaps even shopping for another financial institution or lender to work with.
Although financial institutions are sometimes criticized for “kicking a guy when he is down” because they may raise rates when the farm’s financial position deteriorates, the other perspective is that farmers who manage their businesses and financial position well deserve lower rates since they are lower risk to the lender. That certainly makes some sense to me.
Earl Smith, P. Ag., lives near Sundre, Alta., and does farm and business consulting in the areas of business management, finance and succession. He was previously with RBC Royal Bank where his last position was Manager, Agriculture and Agri-business, Prairies. Contact Earl at 403-586-2504 or [email protected]with questions or comments and for upcoming dates and locations for his Farm Financial Workshops sponsored this winter by Agri-Trend Agrology.