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Keep your eye on 'non-decreasing' interest rates

Jeff Caldwell 11/26/2013 @ 2:12pm Multimedia Editor for Agriculture.com and Successful Farming magazine.

Interest rates are just about as low as they can go. And, even though they aren't exactly expected to skyrocket in the near future, even a pause in the decline in rates that's been underway now for years could have serious implications for farmers' borrowing capacity.

Market-watchers do expect the slide in interest rates to end in the near future, but that doesn't mean they will turn higher immediately. In fact, federal officials will likely take action to keep them at currently low levels in an effort to spur badly needed macroeconomic growth, according to University of Illinois Extension ag economist Gary Schnitkey.

"The decreasing rate period coming to an end does not signal a period of rising interest rates. If certain Federal Reserve Board policy makers have their way, a protracted period of low interest rates could ensue. In her confirmation hearings for Federal Reserve Board chair, Janet Yellen indicated that she prefers to continue the period of accommodative monetary policy," Schnitkey says. "If successful, this policy would lead to a protracted period of low rates, with rate variability similar to that experienced in the last six months. This protracted low-rate period likely will occur, unless the economy unexpectedly grows leading to higher real interest rates or inflationary pressures grow leading to higher nominal rates."

Assuming rates will stay low rather than increase after the general trend of decline ends doesn't mean money and financing is going to stay cheap and risk-free, however. In fact, the opposite could be true; in some ways, a pause in rate movement one way or another can have just as much a hampering effect on financing opportunities than an altogether reversal higher.

Why? Say you buy 80 acres of land for $10,000 an acre and finance it with a 2% interest rate. If it stays at 2%, your real ability to continue to pay for that land won't go down, but it also won't improve as would be the case if the rate continued to decline.

Now, say that interest rate moves to 4% in the next two years. All of a sudden, you're paying $16,000 more for that 80 acres. And, with corn prices near their break-even levels right now, an extra $16,000 may not be the easiest thing to come by in the near future.

"Since the mid-1980s, marginal investment decisions have been aided by decreasing interest rates. For example, there may have been little margin in cash flows from a debt-financed investment at the time the investment was original undertaken. Decreasing rates often led to lower interest payments after the investment, thereby causing cash flows to become more favorable," Schnitkey says. "From 1985 through 2013, 10-year rates decreased an average .26 percentage points each year, leading to a reduction of 1 percentage point every four years. It is unreasonable to expect similar reductions in the future."

So, what can you do? It's all in the margins moving forward, namely expanding them to account for any potential move higher in interest rates that could ultimately undercut your ability to pay down a loan that, under its original super-low interest rate terms -- and stronger grain markets -- was easy to handle.

"Given the end of decreasing rate period, farmers may wish to build more safety margin in their investment decisions. It will be unlikely that decreases in rates will reduce debt-servicing requirements in the future. Moreover, there is a risk of increasing rates, leading to larger fund requirements to service debt," Schnitkey says. "Some may have gotten conditioned by falling interest rates during the past three decades of decreases. Almost by necessity, the era of decreasing interest rates is ending. Therefore, debt-servicing requirement made on investments today likely will not be decreased by falling rates. This suggests additional reflection when undertaking debt-financed investments."


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