No miracle cure to interest rate burden

Following a period of relative stability, bank base rates have been rising steadily and now stand at 5.75 per cent. The first thing to do is put that rate into some form of perspective.

Until 2001 rates were above 6 per cent, but have been below 5 per cent for the past five years. However, in the late 1980s rates were as high as 17 per cent and throughout the early 1990s fell gradually but for most of that period were in excess of 10 per cent.

So although increasing, rates are still relatively low compared to the recent past. The problem is that businesses have got used to low rates and the recent pace of increases – 28 per cent in the last quarter – is substantial and pushing up costs on farm.

However inflation, which interest rates are used to control, has been running at under 3 per cent so the cost of borrowing has risen by 10 times inflation. Many experts expect a 6 per cent bank base rate by November.

Most farmers will pay between 1.5 per cent and 2 per cent over the bank base rate. Some very secure and low risk businesses can negotiate rates down to as low 1 per cent over base but equally more risky businesses will be paying as much as 3.5 per cent over base.

The average dairy farmer on Promar Farm Business Accounts (FBA) to March 2006 had total borrowings of £250,000 spread between overdraft, loans and mortgages.

The average cost of borrowing last year (interest and charges) was approximately 1.6ppl, but the rate increases will push total borrowing costs up by over £3,000 – equivalent to 10 per cent of last years average profit.

I suspect that the FBA results to March 2007 will show a higher level of overall borrowings, a legacy of last year’s profits being insufficient to cover drawings and investment. The consequence of this is that businesses will have had to borrow more money.

As the vast majority of farms are funded by borrowed money, the question is what can be done to offset the rate increases?

The first bit of advice – make sure you score some Brownie points with the bank manager and don’t keep the manager in the dark.

Get your accounts up to date so you can demonstrate where the business is and where it is going.

Bank managers want facts not wishful thinking. Consider investing in detailed management accounts like FBA so you really understand, and can demonstrate, the strengths and weaknesses of the business.

As well as historic information, produce a realistic budget and cashflow to show where the business is going.

This information can also be useful if you are considering changing banks, but be careful. While lower rates may be negotiable, there will always be arrangement fees that aren’t and these will quite often wipe out any interest rate benefit, meaning you end up with all the hassle of changing banks for little or no benefit.

Do not assume changing banks will solve the problem.

It is more important to get a good balance between structured loans and overdraft with the best possible terms for all mortgages and loans.

Overdraft is traditionally viewed as short-term borrowing but in reality it is often the longest term borrowing as it never goes away as there is no discipline to repay.

Try to ensure you are always paying borrowings off, but do not be tempted to try and pay them off too quickly. The key word is ‘affordability’.

While repaying a loan quickly may reduce the total interest paid it can have a significant impact on cashflow and restrict the cash available for other purposes.

In many cases, farmers I see would have been better to extend the repayment period to reduce the payments made but leave cash in the business.

I would advise all farmers to look at the loan repayments being made, decide on the level the business can genuinely afford and renegotiate the terms accordingly.

The other factor to consider is the issue of fixed versus variable rate loans and in most cases the decision will be down to individual circumstances and attitudes to risk.

With variable rates you are exposed to the good times if rates drop but equally will be hit as rates rise. Fixed rates give a degree of protection and certainty but can work against the borrower if rates drop over the life of the loan.

In most cases a balance of fixed and variable rate loans gives the best way to reduce risk and worries over repayments.

Farmers should carry out a sensitivity analysis to determine how vulnerable they are to interest rate increases. For the average FBA farmer the answer is a £2,500 increase in borrowing costs for every 1 per cent increase in interest, assuming all loans are on a variable basis.

Finally, take a hard look at the need for new borrowings and investment. The best way to reduce borrowings is to not spend the money in the first place. If you do need to invest, look at the various options carefully in terms of interest rate, repayment period and monthly costs. How will the new borrowing fit within the present borrowing portfolio and is it really affordable?

Faced with a period of higher interest rates, careful planning and working closely with your bank manager will be key to controlling borrowing costs.