in today’s economy

By Jim Garvin, Senior Vice President – Finance and Information

Every day 1st Farm Credit Services clients select interest rate options for their loans. Clients have a wide range of interest rate options from which to choose, especially for real estate loans – including variable, adjustable and fixed rates for varying periods of time. This always brings up the question of what factors should a client consider when making this decision, particularly in light of the current economy.

When making this important decision, clients should always look at their own financial position. Presently, short-term variable interest rates are about 2.50 percent below medium-term fixed interest rates. Everyone wants to save on interest expense and there is a real tendency to select the shorter-term product simply because of price. However, clients need to consider the impact rising interest rates may have on their future profitability.

If a client does not have high debt levels, relative to equity, and believes he can withstand the potential additional expense that rising interest rates might bring, then selecting the short-term interest rate may be the right decision. Conversely, if the client’s current profitability is low and rising interest rates would place him in a financially uncomfortable position, he should consider choosing an interest rate that has a longer term.

Clients should also consider their ability to repay loans quickly. For loans that will be substantially repaid in the next several years, the shorter-term, lower interest rate is probably the best decision. But for loans that will be outstanding for years to come, clients should consider locking in a longer-term rate, either for the entire loan, or at least a portion of it. Long-term real estate loans in particular can benefit from this multi-rate strategy wherein a portion of the loan is priced short-term while the remainder is priced for a longer period.

In the past several years, interest rates have fallen and, just when most felt they were poised to rise, fell again. At times, some of us have asked ‘How low can interest rates go?’ The overnight lending rate between the Federal Reserve and the banking community is presently at 1.00 percent. Just 30 months ago, this rate was 6.50 percent. Wow! This is an unprecedented drop in interest rates.

Although it is very unlikely that interest rates will rise as quickly as they have fallen, producers should be aware of several key drivers that may cause interest rates to rise.

One of the key factors that affect the U.S. economy is consumer behavior. Roughly two-thirds of the nation’s economy is driven by consumer purchases. Therefore, ‘as the consumer goes, so goes the economy’. Consumer confidence is one leading indicator of how individuals feel about the economic future of our national economy. This indicator provides a collective view of consumers’ willingness to spend, save or reduce debt.

Another key indicator that impacts consumers is the unemployment rate. The higher the unemployment rate, the less collective consumer buying power in the marketplace. In addition, high levels of unemployment also create fear and uncertainty in individuals about keeping their jobs. Consumers are less likely to spend in this mindset.

Reduced spending on the part of consumers causes price pressure for American business. Likewise, when consumers have more disposable income and are confident about their financial future, they are more willing to spend. Increased spending leads to economic growth for our national economy and can lead to inflation. Consumer attitudes and behaviors have a major impact on the future of interest rates.

The Federal Reserve Board (FRB), led by Alan Greenspan, watches all of these components very closely. When the FRB is uncomfortable about inflation levels and/or uncontrolled growth in our nation’s economy, they declare a ‘bias towards increasing interest rates’ and eventually increase the fed funds target rate. This action causes all short-term interest rates in our nation to rise.

Clients can anticipate the future of interest rates by maintaining a close watch on consumer spending, consumer confidence levels and the Federal Reserves Board’s bias towards interest rates.   When these early indicators start to change, clients should consider repositioning some of their debt to longer-term interest rates.