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Variable rate
product
The short term
variable interest rate loan product has the benefit of
delivering the lowest interest expense available in the
marketplace at that current time. However, the client must
speculate on the potential risk future interest rates may
rise and negate the savings currently enjoyed. If the
producer believes he can payoff this real estate mortgage in
a relatively short number of years, the variable interest
rate may be the best overall option.
However, if a
client believes a good portion of this debt will be
outstanding for a term of 5 years or longer, then this
interest rate risk may not be warranted. Much like the
price of corn and beans, the producer cannot lock on a
longer term interest rate that has passed once interest
rates begin to rise.
Adjustable
rate product
An option that
many producers employ to cover such risk is the benefit of
pricing their loan on a mid term interest rate product. In
this situation, clients will not bear the risk that the
interest rate will change monthly, but instead enjoy a
reasonably low interest rate for a one, three or five year
period depending on the product selection. These in fact
are 1st Farm Credit Services’ most popular
products.
These products
have offered a simple way for large and small producers to
keep their interest rates manageable, and prevent paying a
higher interest rate premium in exchange for long term
protection. However, this approach still places the
producer at risk in a rising interest rate environment. If
interest rates increase, rate protection only lasts for the
number of years that the adjustable term was priced.
Clients are subject to the current market interest rates at
the time of repricing.
Fixed rate
products
Some producers
opt to play it safe and lock in a long term fixed rate loan
products. With this approach, clients remove the risk their
interest cost will rise in future years. However, they pay
a premium to remove this risk. If interest rates rise,
these clients will be happy with the choice of a long term
interest rate. On the other hand, if interest rates stay
relatively flat in the coming years, then this approach buys
the producer more interest rate protection than he needs.
Wouldn’t it be
nice if we could find a way to price a loan with all of the
following?
ü
A lower interest expense like variable
interest rate provides
ü
Avoidance of the risk of rising rates at a
reasonable price
ü
Security of long term interest rates for
rising market rates
Split loan
pricing
Some 1st FCS
clients utilize an interest rate strategy called
split-pricing. Split-pricing allows an individual to
partition his real estate mortgage into separate pieces and
choose separate pricing terms for each piece. Using the
previous scenario, a client might elect to price half of his
$300,000 mortgage on the variable interest rate, and the
remainder on a long term fixed interest rate.
By using this
approach, clients benefit from a lower weighted average
interest rate on the total debt amount, while locking in a
long-term interest rate on a portion of their debt.
Individuals choose a combination of different loan products
under the split-pricing program, thus effectively creating
an interest rate hedge on their loan.
Producers can
blend variable, adjustable, and fixed rate loan pricing to
achieve their optimal level of interest rate hedging. 1st
Farm Credit Services has a wide range of terms for both the
adjustable and fixed rate loans. Clients, with the help of
their 1st FCS Vice President, may select a combination of
loan products that best suit their situation and appetite
for risk.
For example, a
client who is willing to take more interest rate risk and
expects to repay his loan much quicker than the maturity of
the note could combine a variable rate with a mid-term
adjustable loan product. This would yield a very low
interest rate today, with some protection against interest
rates rising over the next few years.
Conversely,
another client who wants to avoid much risk due to rising
interest rate and who expects to repay the loan over a
longer period of time may combine an adjustable rate loan
product with a fixed rate loan product. The combination of
the two offers the producer an interest rate that is lower
than a fixed rate for the whole loan, but provides security
against rising interest rates.
Loan
prepayments
Many 1st
Farm Credit Services clients repay their loans more quickly
than required by making extra principal payments above and
beyond their scheduled principal payments. When setting up
a split-pricing strategy, clients can select loan products
that are freely prepayable, or loan products that have
prepayment restrictions.
In either event,
clients can use the split-pricing to their advantage. When
a client has freely prepayable loans, he can choose to repay
either loan segment. If interest rates are rising, the
client can apply all of his extra principal payments to the
loan segment that has the most risk to rising interest
rates.
By doing so, the
client leverages the other loan segment that is locked into
a longer term interest rate. The converse works as well.
If interest rates remain flat or fall, the client can apply
his extra principal repayments to the higher interest rate,
allowing the other loan segment to gradually reprice to a
better interest rate.
The strategy
discussed in this article is primarily focused on average to
large real estate loans. This strategy is not offered for
operating and equipment loans. If you have not positioned
your real estate loan for the long term, call your 1st
Farm Credit Services Vice President. Our team of financial
professionals will help you identify the best combination of
loans products for your needs.
When you need a new real estate loan, or want to re-price
your current real estate loan, call your local 1st
FCS professional or call 1-800-444-FARM. |
