What to do when the interest rates are so high
In view of rising interest rates, an issue that may come up during mortgage loan term negotiations is whether to lock into a fixed long-term mortgage rate or stay in a variable rate. Dean Dyck, farm business management specialist with Alberta Agriculture and Forestry looks at the factors to consider.
“Knowing your interest costs and your farm’s sensitivity to an interest rate increase is a good start,” says Dyck. “Should farm margins change, and weather events happen, it is important to figure out in advance whether the farm’s loan repayment capacity can handle a 2, 4, or 6 per cent increase in interest rates.”
Debt servicing analysis is broken down into two main sections – debt servicing capacity (DSC), and debt servicing requirements (DSR). These are calculated as follows:
• DSC is accrued net farm income + depreciation expense + interest expense + off-farm income – family withdrawals – farm income tax paid.
• DSR is the total accrued interest expense + total term loan principal payments (for a fiscal year).
“The difference between DSC and DSR must be positive,” says Dyck. “Once you have done the calculations using current numbers, see if the farm can withstand an interest rate increase of two per cent. Add two per cent to your average interest rate on all of the farm’s debt to calculate the total accrued interest expense. Then check to see if the difference between your DSC and DSR is still positive, or if the increase in interest rate significantly changes your repayment risk.”
Lenders often use a debt servicing ratio (DSR) calculated as DSR = DSC / DSR. Industry benchmarks for this ratio vary from one financial institution to another, but generally, the following benchmarks apply:
• Greater than 1.5 is low risk.
• To 1.5 is medium risk.
• Less than 1.1 represents high risk. “Remember, interest rates are part of your interest expense calculation, and your interest rate does not show up on your income and expense statement,” says Dyck. “The other part of the calculation of interest expense is what you owe. If, in the short run, you have