Farm Credit Canada (FCC) recommends that farmers and agribusiness operators consider reviewing their financing strategies in light of recent Bank of Canada statements.
The Bank of Canada’s key interest rate remains unchanged at 1% and the Bank is closely monitoring inflationary pressures for signs that might warrant increases in the overnight rate.
The Bank of Canada’s overnight target rate influences variable mortgage rates. When the overnight rate changes, the prime rate typically changes by the same amount. The Bank increased rates three times in 2010. No changes have been made since last September, as the bank officials monitor the economy’s progress.
“Because mortgage costs are often a key cost in a farming operation, one of the most frequent questions we hear is: ‘Should I go with a fixed rate or a variable-rate mortgage?’” said FCC vice-president of treasury Don Stevens. “The answer is, that it depends. Sound information and an assessment of personal risk tolerance can help make the decision easier.”
When interest rates are low, variable rate loans are a popular choice. In the past year, about 80 per cent of new FCC loans were made using the variable rate. About two-thirds of FCC’s $20-billion portfolio consists of variable rate loans.
“From 2005 to 2007, when the Bank of Canada was increasing the overnight target rate, FCC experienced an increased demand for fixed rate mortgages and saw conversions from variable to fixed rate,” Stevens said.
FCC senior economist Jean-Philippe Gervais added, “No one knows what the Bank of Canada will do. However, if you examine past trends to keep inflation or inflation expectations in check, we expect that interest rates will be higher in 2012 than they are now. A consensus among leading market economists is that the overnight rate should increase by 175 basis points over the next 18 months.
If that prediction is accurate, it should imply a 4.75 % prime rate by Dec. 31, 2012. The prime rate is currently 3% and the 10-year average for prime is 4.40%.
“If a farmer is already carrying significant financial risk, then reducing interest rate risk may be a smart strategy,” said Stevens. “Although everyone wants to save money, sometimes it’s prudent to pro actively take risk off the table. I’m not saying that everyone should lock in; however, all producers need to understand what different scenarios might mean to them and do what’s right for their business.”
One method to reduce interest rate risk is to have more than one mortgage, with different terms and a combination of fixed and variable rates, which means that the borrower’s debt reprices at different times. Of course, that has to be weighed against the complexity of managing multiple mortgage terms.
Here are some other considerations:
Fixed rate advantages
– protection against rising rates until the end of the fixed-rate interest term (the longer the term, the more constant the costs); and
– easier to predict interest and principal costs to calculate profit and losses.
Fixed rate disadvantages
– generally, fixed mortgage interest rates are higher than variable. Therefore, the longer the term, the higher the interest rate; and
– break fees or prepayment penalties may be incurred if the loan is paid off prior to the end of the term.
Variable rate advantages
– studies show that historically, variable rate mortgage owners pay less most of the time if interest rates are falling; and
– ability to convert to fix without penalty.
Variable rate disadvantages
– risk of higher rates if prime increases.
The success of individual producers affects the success of the industry. Find online information about interest rates from FCC at http://www.fcc-fac.ca/en/AgNews/interest_rate_e.asp.
Producers who want to review or establish their financing strategy can contact the nearest FCC office at 1-888-387-3232.
FCC is Canada’s leading agriculture lender. It provides financing, insurance, software, learning programs and other business services to producers, agribusinesses and agri-food operations.
For more information, visit www.fcc.ca.
