Basics of an Ag Real Estate Loan
The title of this article, while meant to convey a simple and easy to read piece, may belie the complexity and multitude of options available when purchasing and financing farm land. Financing options are plentiful: fixed vs variable rate, various mixes and matches of terms and amortizations, balloon payment or fully amortizing, open prepayment options or prepayment penalties, and so on. Once a loan product is chosen, it is typically difficult and costly to undue or change. Your choice is final until the loan runs its course or one chooses to refinance. While the availability of options is great from a borrowing standpoint and for the ability to customize the borrowing experience, it also requires a certain level of understanding to make an informed decision.
The Ag Loan Process
There really is no set process when it comes to buying farm land. Depending on the borrower and their relationship with the lender, the conversation may start prior to identifying a specific farm when there are only ideas being bounced around, or there may be a signed purchase agreement and the borrower needs to close by a certain deadline. Regardless, the conversation will have to gravitate towards a few common items: where will the down payment come from or will additional land be pledged? What loan product would best suit the situation given the indented use of the farm, future plans of the borrower and interest rate risk tolerance? How fast can the loan be approved and closed and how much will it cost? What information does the lender need to get the credit approved?
To start the credit process and assess the creditworthiness of the borrower, lenders will typically request a current balance sheet, historical balance sheets if they are available, three years of tax returns and a cash flow projection. The lender will pull a credit bureau report and may ask for verification of liabilities not shown in the credit bureau. There may also be requests to verify assets such as savings and investments. The information collected in the credit process will help the lender provide feedback and guidance to the borrower in choosing a loan product.
The Down Payment
The lender will require a down payment, either with cash or with the availability to finance another farm. Lenders typically limit loans to 60 or 70% loan to value, usually of the lesser of purchase price or appraised value. Some exceptions may apply, for instance if the purchase is a non-arm’s length transaction (a non-market purchase, perhaps from an immediate family member). As a borrower it is good to calculate the estimated debt service payment per acre or productive acre of farmland. The loan payment will depend on the loan product chosen, but it will put the payment in perspective and is especially relevant to compare to a cash rent equivalent for the same land. If the debt service payment will need to be subsidized and is not likely to be made from normal operations on that farm alone, the borrower will need to have a plan on how the payment will be made from additional sources. The debt service payment can also be reduced with a larger down payment and a smaller loan.
Loan products differ primarily by their term, amortization, interest rate, interest product (adjustable or fixed), payment frequency and ability to prepay the loan with or without penalty. For this article we are assuming the same credit risk profile of a borrower in all of these scenarios. However, it is worth noting that lenders will consider the creditworthiness of the borrower when considering an appropriate loan product and rate.
The term of a loan means the life of a loan. A five-year term with a 20-year amortization means the loan will mature, or balloon, in five years but is scheduled to be repaid over a 20-year period. Balloon payments provide a tradeoff: they are an opportunity to refinance, change products, or consolidate debt, but the balloon refinance usually means added costs in terms of a new appraisal with the renewal of the loan and may also come at an inopportune time for the borrower. Agriculture is cyclical and a ballooning mortgage in the down side of the cycle may cause some added stress.
The term and amortization will not match unless the loan is fully amortizing. The amortization of a loan refers to the amount of time the loan is scheduled to be paid back and usually ranges from 10 to 25 years but may be shorter or longer under special circumstances. A longer amortization typically means a higher interest rate. Payment frequencies are commonly tied to the source of cash flow anticipated to repay the loan. Farm land is usually on a semi-annual or annual payment schedule while loans for a hog confinement may be on a monthly repayment, in order match the income source of the property. A more frequent payment frequency will have a lower interest rate and will also mean less interest paid. One can usually get a lower interest rate if there is a prepayment fee or penalty, as the lender has a general assuredness the loan will not be paid off early. Open prepay loans have a higher interest rate because the lender may be refinanced at any time without penalty.
When considering interest rate products, fixed interest rates are typically higher than floating or adjustable interest rates. A fixed interest rate is essentially a hedge against rising rates and like other hedges, comes at a price for the borrower. Fixed rates are less risky for the borrower but can be more risky for the lender. Variable or adjustable rates will be lower but carry more risk for the borrower in a rising interest rate environment. Conversely, variable rates will be an advantage to a borrower in a decreasing rate environment.
How An Ag Loan Works
Interest rates will be the highest with a long term, fixed rate, annual payment and open prepay loan when compared to a shorter term, variable rate, monthly payment and a prepayment penalty loan. With the amount of options at hand it is recommended that one have a well-seasoned lender that can explain the options available and the various trade-offs to the borrower. The risk tolerance of the borrower, intended use of the farm and future plans of the operation will all play in to the decision-making process.
Ben Lundgren current serves as Credit Analyst Manager at TS Banking Group: www.tsbg.com. Lundgren has over eight years of experience in agricultural credit underwriting and analysis. TS Ag Finance, a division of TS Banking Group, provides professional expertise and competitive long term fixed interest rate products for farm real estate loans. If you are purchasing a farm or want to refinance existing farm real estate loans into a long term (up to 30 years fixed) fixed interest rate loan please contact TS Ag Finance. Learn more at www.tsagfinance.com!