Taking Calculated Risks in Lending
Farmers are in the business of assessing risk. When you plant your corn in the spring, you are taking a calculated risk. Based on your previous experiences, you have calculated the risk that your crop may get flooded, destroyed by hail, eaten by pests, or choked by weeds as low enough to be worth the initial investment of time and money to put that seed into the ground. Furthermore, you calculate that the risk is tilted in your favor, and that you will ultimately be able to profitably feed or market that corn crop after harvest.
You also assume risks when you borrow money. You assume the risk that your business or health will fail, and you won’t be able to pay back the loan. However, another risk worth considering is the increase or decline in interest rates during the time you have money borrowed.
WHY IS INTEREST RATE A RISK?
- You borrow money on a variable interest rate and rates go up above where you could have locked in a five or ten year fixed rate.
- You lock in a fixed rate for some period of time and interest rates fall such that you find yourself unable to take advantage of lower interest rates.
- You lock in a fixed rate for a period of time. This favorable fixed rate expires and you find that current rates are a few percentage points higher than what you had been used to paying.
But risk is not a bad thing if it is properly mitigated or managed.
So how do you mitigate the aforementioned possibility that interest rates will fluctuate during the time you have money borrowed?
When you are calculating your loan payments for a new venture, use a higher interest rate than what you think you can get. For example, you are looking to purchase a farm.
- You borrow $700,000 for 20 years with a short term fixed rate at 5.25% with a monthly payment of $4,750 a month.
Stress Test Scenario
- When figuring if you can afford this $700,000 loan you figure the interest rate at 6.25% which results in a monthly payment of $5,155.
If the thought of paying an extra $405 a month scares you or would cause financial stress for you, then you should reconsider whether or not this is a wise move.
Another option to help mitigate interest rate risk would be to split this $700,000 into two loans. Consider taking a longer term fixed rate on one of the loans and a shorter term fixed rate or variable rate on the other loan. The $700,000 doesn’t have to be split equally. This can also be a nice option if you plan on making extra payments on your loans. You can focus your extra payments on one loan and try to eliminate that payment at an accelerated pace.
At Farm Credit, we also realize the risk in borrowing in money in today’s volatile environment. If you do choose to lock in a fixed rate and rates would happen to fall, we do have the ability to lower that fixed rate for you, down to the going rate, saving you money.