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4 Rules on Refinancing Your Farm
Your lender works hard to keep you as a client, but even the best banking relationship can come to a close. Your farming operation may expand beyond the comfort zone of your lender. Your loan officer may relocate or retire. Your bank can scale back or withdraw from agriculture production. Your farm may not qualify for a loan renewal in times of low commodity price cycles.
Because these events can occur, it pays to be prepared for a farm refinance. First, understand how lenders evaluate risk and the type of financial metrics they take into consideration when assessing a farming operation. Although these aren’t all the factors lenders examine, there are four rules that form the pillars of farm refinance:
- The Rule of 90
- The 85% Debt Service Limit
- The 25% Operating Budget Rule
- The 75% Equipment Loan Rule
Pillar #1: The Rule of 90
The Rule of 90 relates to real estate mortgages, and it combines two key inputs: the maturity length of the mortgage (in years) and the ratio of the loan amount-to-property value (%). The rule says that the sum of the loan term plus the loan-to-value ratio may not exceed 90. For example, if you seek a real estate loan with a 20-year maturity, the requested loan amount cannot exceed 70% of the real estate’s appraised value (20 years + 70% loan/value ratio = 90).
The Rule of 90 creates a balance between the length of a real estate loan and how much you can borrow against your land. For a longer-term loan maturity, the loan amount must be a smaller percentage of the land value.
The takeaway is to understand your current land values and apply the Rule of 90 to predict your mortgage lending limits.
Pillar #2: The 85% Debt Service Limit
The 85% Debt Service Limit relates to the amount of annual loan payments (principle and interest) that a farm operation can safely support from its earnings. The limit states that a farm’s annual loan payments cannot exceed 85% of its net income + interest and depreciation (I+ID). For example, a farm with $300,000 of I+ID can safely support $255,000 of annual debt service payments ($300,000×0.85 = $255,000).
Current commodity prices impose severe restrictions on a farm’s ability to comply with the 85% Debt Service Limit. In response, some lenders have increased this percentage for borrowers with high equity in their farms.
The takeaway is to write annual budgets that include conservative cost and income estimates, then apply the 85% Debt Service Limit to define the natural boundaries of how much your farm should expect to borrow.
Pillar #3: The 25% Operating Budget Rule
The 25% Operating Budget Rule relates to managing the downside risk of unexpected future results. It is prudent to fund at least 25% of your farm’s projected annual operating costs with your own cash. Since operating losses rarely exceed 25% of a farm’s total operating costs, self-funding at least 25% of budgeted annual costs mitigates your lender’s financial risk and makes your farm more creditworthy. Having skin in the game is a clear message to lenders about the financial health of a farm.
Pillar #4: The 75% Equipment Loan Rule
The final pillar of farm refinance is the 75% Equipment Loan Rule. Farm equipment and machinery is a depreciating asset that can quickly lose value. When refinancing farm equipment, you should expect to borrow no more than 75% of the equipment’s value.
Equipment loans typically have higher interest rates than real estate loans, so minimizing equipment loan amounts will lower your farm’s ongoing interest costs.
The four pillars of farm refinance are interrelated, so it is important to understand how the strength or weakness of one pillar impacts the other three. You may not know when you’ll need to refinance your farm, but you can be certain that lenders will appreciate the financial structure of your loan request when it is well supported.
About the Author
Brent King is managing director with the Kansas City office of GlassRatner Advisory & Capital Group LLC.