Obtaining Finance and Credit: Unit 6

Obtaining Finance and Credit: Unit 6 By: Eslon Ngeendepi EAR212s 2013

Objectives • Define capital, credit and loan. • Define the types of loans. • List the different sources of credit for farmers. • Explain the credit evaluation process for farmers. • Explain the terms and conditions of loans. • Explain the different types of interest rate and calculations. • Explain the concept of loan maturity and collateral. • Define the debt repayment capacity. • List the terms of repayment.

1. Capital, Credit and Loans • Agricultural Capital: Goods used to produce other goods which generate income over extended periods of time e.g. equipment, house & livestock. • Farm credit: Resources/part of capital/money used to purchase assets or operate a farm.

Types of Credit or Capital • Real estate capital or credit: Credit/capital used to purchase farm land, real estate or add improvement to farm property/assets. • Working capital or credit: Capital used to purchase productive inputs that are used for more than 1 year including breeding stock, equipment and machinery. • Operational capital or credit: Capital used purchase inputs that are consumed in the production process e.g. seeds, fertilizer, etc.

Productive vs Consumption Credit • Productive Credit: Form of credit used to increase production or income or used to purchase land, livestock, equipment, seed, fertilizer, etc. • Consumption Credit: Credit used to purchase consumable items used by the family and does not contribute to business income. E.g. credit for food, clothing, household goods etc.

Types of Agricultural Loans or Credit • Short-term loans • Operating loans or credit: Loans for short-term seasonal needs, often for year or less & are to be paid from that years production. E.g. Seed, chemicals, fertilizers, feeder stock. Security is often a lien on products produced. • Open account credit or line-of-Credit: With suppliers or banks that specifies the timing of disbursement and payment of loan. Two types: • Intermediate Credit or loans (2-7 years) • Credit for depreciable assets and capital investment (farm equipments, building, etc) or refinance debts incurred for capital purposes to be repaid over a period of 2-5 years or more. Collateral or security: Crops or real estate. Working capital loans: For longer term assets breeding stock, building renovations. Repayment period: 5-7 years. Security or collateral: Mortgage on personal property financed. • Long-term Loans, Real Estate Mortgages or Contract Financing: Loans to acquire, construct, improve land & buildings or to consolidate other loans. Repayment period: Longer than 10 years. Security: Lien on real estate.

Sources of Ag Financing There are four basic sources of Agricultural financing. • Private Financing • Commercial Lending • Farm Credit System • Farm Service Agency • Insurance firm

Private financing • If available this can be your best option as it will allow for more flexibility and less restrictions. • In private financing you only have to convince yourself or usually a friend or relative that your proposal is sound and secure enough to invest. • This can also be less restrictive. This can be a good source of financing in conjunction with other commercial financing providing the much needed collateral position they will require.

Commercial Lending • This would include banks, credit unions, credit cards etc. • Banks would be the most common source of credit to the Ag sector. • The first bank to contact is always your own bank. They will know you the best and are more likely to help if you have a history with them. • The problem is that more and more banks are moving away from Ag lending. You may have to go out of your area to find a bank that would do Ag financing. When applying for a loan you need to have done your homework. • When you present a plan to your bank, have it supported with realist projections including a solid marketing plan. The first impression will be the lasting one. If you are shooting in the dark it will be apparent and your success unlikely. • E.g. Agribank and the 4 other commercial banks in Namibia

Farm Credit System • This would be the Federal Land Bank or Production Credit System. They are found in all rural areas and are exclusively involved in Ag Credit. • They are not part of the government although there is some oversight. • They are producer owned so can provide better rates and terms on real estate loans and have a complete portfolio of real estate and operating type loans. • With their total involvement being in Ag lending they will have a good understanding of what you want to accomplish.

Farm Service Agency • This is an agency of the U.S. Government that provides assistance and support to farmers. Within FSA there will be the farm loan department and they will have representation in each region throughout the U.S. They are able to make direct loans to farmers or work with a commercial lender in providing guaranteed loans. • This will allow lenders to make loans that they are not completely comfortable with due to risk or uncertainty since the loan is backed by FSA. • The major advantage to FSA is that they can make loan with little or no equity and are designed to help new farmers and ranchers get into the business of Agriculture. • The drawbacks are that you must meet certain eligibility requirements and they have limited funding.

Choosing a Lender • Borrower need to look for lender offering best deal possible. • Type of financing needed determines the type of lender a borrower chooses. • Short-term loan lenders: Sources- Comm/Agric banks, relatives, input/output dealers, cooperatives. Etc. • Long-term loan lenders: Sources- Agric banks, insurance companies or cooperatives. Borrowers need to identify lenders with whom they can establish long term working relationship with.

Lenders reputation • Honesty & fairness: Lenders must have a reputation of fairness & honesty, success and value the borrowers business. • Agricultural knowledge: Lenders must understand agriculture and the risks involved in agriculture.

Appraising lender’s policy on agricultural loans • Loan terms: Terms offered should match the seasonal nature of farming. • Interest rate charged: Must be in line with agricultural risk and prevailing cost of capital elsewhere. • Security or collateral requirements: Must be fair and competitive. • Service fees: Granting and servicing the loan must be reasonable and fair. • Eligibility requirements: A lender’s eligibility requirements and speed of processing loans must be assessed.

Appraising lender dependability and financial health: Borrower asses lenders financial health because financial difficulties are not the best source of agricultural loans. The agriculture sector requires stable credit sources. • Appraising a lender’s experience in agriculture: Lenders must clearly understand problems in agriculture particularly problems the borrowers is likely to face. Lender must be able to provide borrower with advice when needed.

Lenders evaluation of the borrowers • Lenders will carefully consider borrowers ability to manage their enterprise and repay the debt before the loan is given.

Lender’s Evaluation of Borrowers • Borrowers need to consider the following when choosing a lender: • Their own needs • The lenders reputation • The lenders policies • The lenders dependability • The lenders experience in agriculture

Applying for a loan • The following documents must be handed when applying for a loan: • (a) Need (what) for the loan: Information on what they need the loan for e.g. if loan s needed to purchase a form equipment, information on prices and description of equipment are needed. • (b) Why the loan: Information on why they need the loan and how they will repay (projected budget needed). • Up-to-date Financial Statement: Listing the assets and liabilities. Financial history and farmers record-keeping system must be provided.

When approving a loan lender must consider • The individual borrower • The purpose of the loan • The financial condition of the borrower • The repayment ability of the borrower • The borrower’s collateral- the asset to secure the loan.

Terms and conditions of Loans • Borrower need to understand the loan agreement, loan terms and conditions, i.e. Interest rate, fees, collateral, methods of receiving funds, repayment time and periodic repayment amount, etc.

Terms & documents used in securing loans • Interest rate: Price of using borrowed money. • Determinant of interest rate: • Money supply: M1 or M2 • Demand for credit: ↑demand for credit the ↑rate. • Risk (from borrower to lender): The higher the borrowers risk the higher the rate. • Cost of making and servicing the loans: High cost of servicing loan means the higher rate the lender will charge. • Funds rate (Repo rate): Rate charged by BoN on Comm.Banks & other fin instit. • Prime rate: Rate that financial institution charge their biggest and best customers. Prime based on Funds rate (Repo rate).

Types of interest rates • Fixed interest rates: Loan carries the same interest rate until the loan is paid off. • Adjustable interest rate: Rate that can be changed at intervals as specified in the loan agreement e.g. 6 years loan, interest can be can adjusted once every year. • Variable interest rate: Rate changes based on the market interest rate a specified index or at the discretion of the lenders. Linked to the specified index rate and lender adds a margin to the index rate to determine interest rate. • Interest rate index: Variable and adjustable interest rate are linked to interest rate index. Indices used by lenders include their average cost of funds, prime rate charged at money markets. • Margin: Refers to the % points that the lender adds to the rate index to determine the rate charged to the borrower.

Variable interest • In recent years, it has become common for lending institutions to adopt a variable interest rate policy. • Typically, the interest rate will be stated on an annual basis and will not change more often than once each month. If interest is calculated on the remaining balance method, it can be calculated in a way similar to the process for partial year loans. • For example, if the interest rate was 12 percent for 2 months, 13 percent for 3 months and 14 percent for 7 months, the annual interest amount is: I = A x 0.12 x (2 / 12) + A x 0.13 x (3 / 12) + A x 0.14 x (7 / 12) • If applied to the add-on or discount methods, a new calculation would have to be made each time the rate changed.

Interest rate calculations • Simple Rate Method: Cost of loan is proportional to interest rate. • Interest amount paid= Principal (loan)x rate x Time (years) • Example 2: P x r x T e.g. I= (N$4500) (0.095) (6) • I= N$2565.00 per year • Example 2: • Assume you take a loan of N$23 000 for 3 months at an interest rate of 12%. Calculate the interest amount paid. • Unpaid Balance Method: Interest amount is based on the unpaid loan balance.

Discount Method: Interest cost is deducted from loan at the beginning of the term, making interest rate higher than it appears as the borrower does not have the use of the full loan amount. • The interest is subtracted from the loan amount and the borrower receives the balance. • The total interest charge is: I = A (Actual loan) x i (interest rate) x N (time) • The amount the borrower receives is: L = A - I • Where: L=loan proceeds and • Periodic payment is: Bn = A / N • Using data given as N$3,000 loan amount, 6 percent annual interest rate, over 2 years), the total interest charge is again N$360: I = $3,000 x .06 x 2 = N$360 • The borrower would receive N$2,640: • L = N$3,000 - N$360 = N$2,640 • Periodic payment: repay two instalments of N$1,500 each: • Bn = N$3,000 / 2 = N$1,500

Equivalent or True interest method: This method gives the actual interest borrowers pay as it takes service charges into account. • Formula= (Total charges/one-half the loan) x no. of payments/ no. of years) x (1/ no. payments + 1)

Activity 1 • Suppose that a mahangu farmer decides to borrow N$50,000 for 2 years. The interest and service charges are given as 30% of the initial loan amount. The loan is payable semi-annually in year 1 and quarterly payments are to be made in year 2. • Obtain the total charges. (2) • Calculate actual interest rate the farmer pay? Show all you calculations including the formula used. (8)

Loan Maturity & Collateral • Maturity: Time until the loan is fully due and payable. Shorter maturity result in lower total interest payment and higher loan payment over the life of the loan, but loans with longer maturities will have lower loan payment. • Collateral or security: This refers to the assets borrowers pledge as security in loan transaction.

Long-term farm real estate loan: Collateral is a deed of trust on a tract of land or a house for farm real estate loans or a mortgage on the property. • Operating and intermediate-term loan: Collateral is a security agreement. For intermediate-term loans for equipment or facilities, the security or collateral are the assets being purchased. Operating loans are usually secured by current assets. • Unsecured short-term loans: When producers with a good reputation obtain a short term loan without any security, the loan is an unsecured loan or a signature loan. • Repayment penalties: A repayment penalty is a fee charged by a lender when a loan is paid prior to its maturity.

Determining the Amount of Credit to use in Farming • When borrowing money the following sound credit programmes must be considered borrower: • Will the net returns from the loan cover its costs and repayment? • Will the borrower have adequate income to meet the terms of repayment, both interest and principal, when due? • Is the risk-bearing ability of the borrower sufficient to carry the risk and uncertainty involved with the loan.

Debt-Repayment Capacity • Illustrate the ability to meet loan payments as scheduled. • Farmer should consider the amount of funds available to repay the loan or debt and the terms of repayment. • Assessing repayment capacity must include all income and expenses expected during the loan period.

Available funds to repay loans • Funds available to pay debt obligation (net cash income). • Net cash income from the farm must be higher than cash operating expenses. • Net cash income is the funds available to pay personal living expenses, personal taxes, debt obligations, capital expansion and savings. • Living expenses and taxes have a high priority, thus allowances must be made for these before determining funds available for principal payments. • Interest on debt is considered an annual operating expense, thus the net cash income is reduced by interest payments.

Terms of Repayment • There are two repayment terms: • Time: Length of time over which the loan is to be repaid. • Periodic amount: The amount to be paid periodically. • Two major factors that affect the terms of loans on the debt load to be repaid are: • Years for repayment • Interest rate Extending years of repayment increases the debt load that can be carried. Increasing the interest rate decreases the debt load that can be carried.

Repayment Time • Refers to the time it will take to repay the loan in full. The following methods are used: • Time for short-term or operational loans: • Borrowers billed at the end of the month. • Time for intermediate-length loans: • Repayment time varying from 2-7 years. • Time for budgeted loans: • Lender and borrower determine in advance when loan funds will be needed and the timing for repayment. Funds are advanced as needed and repaid as products are sold. These loans give flexibility in managing cash flow and borrowers pay only for funds actually used.

Periodic Repayment Amount • Refers to an amount to be paid periodically until the loan is fully paid. • Payments on line-of-credit financing generally occur when the borrower has surplus funds. • For intermediate and long-term loans a payment schedule is usually used that specifies principal and interest payments over the lifespan of the loan. • The methods of repaying loans are given as: • The straight-end payment (interest payment): Interest payment and principal paid at the expiration of the loan. • Partial or balloon payment: Fixed principal payment each month during the lifespan of the loan. Payment do not liquidate the principal during the repayment period, hence a large amount, a balloon payment is due at the end of the loan lifespan to finish paying the principal.

Summary • When developing your operating plan, be creative in your approach to obtaining financing. Look at the possibility of using more than one source to provide the best plan.

Be Creative, Adventurous and Persistent in researching all financial possibilities.

Obtaining Finance and Credit: Unit 6