by Courtney Llewellyn
In a perfect world, we’d all have cash on hand to pay for everything we need. Unfortunately, we don’t live in a perfect world, and borrowing funds for large purchases – everything from land to equipment – is a common practice. The good news is you can refinance your loans (when it makes sense to do so) to save money in the long run.
Dayton Maxwell, an ag business professor at SUNY Cobleskill, is well versed in this topic. He recently gave a virtual presentation on when a farm business should consider refinancing.
While some may be all too familiar with loans, Maxwell began by explaining how amortized loans work. Payments remain the same, but over time, the amount applied to interest decreases over time. A loan’s principal pays down faster with increased frequency of payment because less interest accrues. Just because you have a monthly payment doesn’t mean you can only pay once a month.
Before considering any loan, study an amortization table. There is a free one available online at bankrate.com/calculators/mortgages/amortization-calculator.aspx.
“Ask how often your lender will accept payment,” Maxwell suggested. “Paying more often reduces the amount of interest paid and can shorten the loan term.” For instance, if you have a monthly payment of $500, see if you can pay $250 every two weeks instead. In the end, rather than paying $6,000 in a year ($500 x 12 months), you could end up paying $6,500 ($250 x 26 weeks) – putting you slightly ahead of the curve.
“When you finance something, think about financing it on the useful life of the asset,” Maxwell added. “You don’t want to be paying for something that’s depreciated and gone.”
As a general rule, he said single purpose agricultural structures have a useful life of 10 to 15 years and farm equipment five to seven years. Land is not depreciable and almost always maintains its value.
There are a few kinds of debt: A short term debt is designed to be paid off in 12 months or less; intermediate will be paid off in more than one year but fewer than 10 (usually applied to equipment); and long term debt lasts more than 10 years (usually for land).
By definition, refinancing is “the process of revising and replacing an existing credit instrument with a new credit instrument” – a loan – and doing so usually changes the amount being paid by the borrower. “Don’t let the allure of a smaller payment get you!” Maxwell cautioned. “You think it may mean more cash flow, but that’s usually not the case at all.”
He described some scenarios farmers may encounter, beginning with a situation in which a loan’s prime rate decreases, which causes variable interest loan rates to decrease. It’s not really a refinance, he said, but it is beneficial as long as your loan repayment term remains constant.
In the second scenario, a farmer refinances to help pay for the accumulation of unpaid operating expenses over a multi-year period, which happens a lot, Maxwell said. It’s necessary to get the business current and to restore business liquidity.
In this situation, the lender does not charge a fee unless a mortgage is taken as security. It turns operating expenses into term debt, commonly short to intermediate. The important question to ask: “Does this make sense for my farming business?” Maxwell suggested using this option very infrequently, as a temporary solution, as it is not sustainable long term. It must adjust the operating enterprise to create a favorable margin. There is no financial benefit other than liquidity restoration.
In the next scenario, a farmer is refinancing intermediate term debt to … intermediate term debt. The example: A seven-year equipment note has been paid down to two or three years but then termed back out to seven. The goal is to free up cash flow to meet obligations, and it may combine existing debt with new debt.
“This does make sense to restore positive cash flow, especially if you can refinance at a lower interest rate,” Maxwell said. “But it also does not make sense, because you’re financing a seven-year asset for 10 years or more, and it might be worn out.” Additionally, using this scenario could be indicative of inadequate operating margins.
The fourth scenario involves refinancing intermediate debt into long term debt. As in the previous example, this makes sense in returning the business to positive cash flow; it does not make sense because equipment is depreciated when the loan balance is paid to zero. This indicates a serious earnings situation.
In the last scenario, a farmer would refinance long term debt to long term debt. A 15-year mortgage is paid down a few years and then refinanced to 15 years or longer – this is common when interest rates drop. “This maybe makes sense, depending on your current situation versus the new situation,” Maxwell explained. “Long term debt generally limits future long term borrowing capacity.” This option could also be indicative of an earnings situation – but it may free up cash flow for a major capital investment that will grow the income stream or reduce operating costs.
So what should a farm business consider when refinancing? Interest rates are a priority. Maxwell said that if a lender can get their funds cheaper, they will pass that savings on to you. Borrowers need to look down the line to end of the loan too. There are closing fees, attorney’s fees, mortgage filing fees, appraisal fees, title search fees and stock purchases to consider. “At least stay with your loan until you break even on fees,” he advised.
Those with large, expensive pieces of equipment should also think about what remains of that equipment.
When monthly payments start getting heavy on principal – later in the loan’s life – it becomes more difficult to refinance. You have more to work with when you refinance early in the loan period. Refinancing is especially beneficial if the number of periods stays the same and there’s a lower interest rate. If there is an increase in the number of periods then the interest rate must decrease to compensate for the extended term.
“Refinancing may be right for your situation even if it costs more than the loan you’re currently in, especially if it results in a capital investment to improve efficiency and productivity,” Maxwell concluded, but warned, “Beware of perpetual refinancing!”