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An important part of managing a farm business is managing debt.\u00a0 Producers who utilize debt effectively can increase the profitability of their operation.\u00a0 However, borrowing comes at a cost.\u00a0 Today, we\u2019ll discuss the different types of loans available to producers and their structures. We\u2019ll also look at how different loan structures impact the cost of borrowing.<\/p>\n
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In general, there are three types of farm loans:<\/p>\n
Producers use operating<\/strong>\u00a0loans<\/strong> to finance input purchases, pay for other expenses, or cover short-term cash shortages.\u00a0 Operating loans might take the form of a short-term note with a bank or a line of credit either with a bank or an input supplier.\u00a0 Normally, borrowers must pay back operating loans within a short period of time, likely a year or less.<\/p>\n Equipment loans<\/strong> provide funds for purchasing equipment such as tractors, harvesters, and related equipment.\u00a0 Producers pay off equipment loans over a longer period, generally 3-10 years, depending on the size of the loan.<\/p>\n Finally, producers use real estate loans<\/strong> to purchase or make improvements to land.\u00a0 Borrowers pay these loans back over long periods, generally anywhere from 10-30 years.<\/p>\n How a lender structures a loan will have a significant impact on both the total cost of the loan and the producer\u2019s ability to make payments from one period to the next. \u00a0In general, a loan\u2019s structure takes four things into account:<\/p>\n Loan term<\/strong> refers to the length of time between when a loan starts and when it must be repaid.\u00a0 It describes how long a borrower has from the time the loan begins to pay back the loan principle and any interest that accrues while the loan is in effect.<\/p>\n A loan\u2019s interest rate<\/strong> is the cost of the loan.\u00a0 It is the amount charged by the lender to make the loan, usually calculated as a percentage of the loan\u2019s value.\u00a0 Lenders sometimes offer the option of choosing either a fixed or variable interest rate on a loan.\u00a0 With a fixed rate loan, the interest rate charged on the loan principle stays the same throughout the loan term.\u00a0 The interest rate in a variable rate loan will change as interest rates in the broader economy change.\u00a0 As interest rates increase, the loan charges more interest.\u00a0 As interest rates decrease, the loan charges less interest.<\/p>\n Some loans require the borrower to offer collateral<\/strong> to secure the loan.\u00a0 Generally, this will be something tangible that the lender can take possession of to limit their losses if the lender defaults on the loan.\u00a0 For agricultural loans, this might be land, equipment, or commodities produced by the farm.<\/p>\n Finally, repayment<\/strong> refers to how borrowers make payments on principal and interest.\u00a0 Short-term loans may require that borrowers pay all of the loan principal and accrued interest at once at the end of the loan.\u00a0 Equipment and real estate loans are often amortized.\u00a0 That is, payments on principal and interest are made periodically during the loan term.<\/p>\n Most lenders can be flexible when it comes to setting a loan\u2019s terms to meet the borrower\u2019s needs and their ability to make payments.\u00a0 For example, a lender may offer a longer loan term at a slightly lower interest rate to make regular payments more feasible for the borrower.\u00a0 That said, a longer loan term, even at a lower interest rate, might cost more in interest over the life of the loan.\u00a0 For this reason, it\u2019s important to consider how different loan structures impact a loan\u2019s total cost.<\/p>\n To illustrate how loan structure affects loan costs, we will consider two possible loans.\u00a0 In both cases, the borrower wishes to secure a $50,000 equipment loan. \u00a0The first loan requires monthly payments for 5 years at 8.5% interest.\u00a0 The second loan requires monthly payments over 6 years at 7.25% interest.\u00a0 In this example, we will focus on the difference in interest costs and assume that all other costs related to procuring these loans are the same.<\/p>\n Table 1 illustrates the payments to principal and interest in the first 3 periods and the last 3 periods for the first loan:<\/p>\nLoan Structure<\/h3>\n
Impact of Structure on Loan Costs<\/h3>\n
![\"Table](\"https:\/\/agrilife.org\/agecon\/files\/2024\/10\/Table-1.png\")
![\"Table](\"https:\/\/agrilife.org\/agecon\/files\/2024\/10\/Table-2-1.png\")
<\/p>\n![\"Table](\"https:\/\/agrilife.org\/agecon\/files\/2024\/10\/Table-3.png\")