In the dairy industry, we are accustomed to wide swings in milk prices and feed costs, but we haven’t had to worry much about rising interest rates for some time. That changed earlier this year when the Federal Reserve began a series of Fed Funds rate increases to combat high inflation levels. As a result, short term rates have more than doubled this year with the Prime Rate increasing from 3.25% to 7.00 % over an eight-month period. Fixed rates for term loans also increased sharply in response to both inflation and the push from higher short-term rates. While it can feel like interest rates are another area that we can’t control, there are steps that we can take to manage and continue to use debt appropriately to support our dairy business success. These steps can include the following:
Don’t overreact. While the rate increases this year feel dramatic, we were coming off a period of very low rates. Prime rates of 3.25% and fixed rates under 4.0% were exceptionally low. Most farms were able to lock in lower rates on term loans over the past few years to cushion the rate increases this year. Our interest expense costs on farms are still reasonable by historical measures. We are also coming off several profitable years and are in a better financial position to handle this rate cycle.
Manage debt service relative to your production and revenue. On an ongoing basis, we like to see annual principal and interest payments total less than $2.50 per cwt of your milk production. That will help ensure that debt costs don’t eat up too large a share of your milk check. With higher interest rates, we may need to extend amortizations on loans for major capital purchases to lower the annual principal payments.
Analyze projected returns relative to debt service for major investments. Facility expansions or upgrades, robotic dairy and significant land purchases may push annual debt service costs over the $2.50/cwt guideline, particularly with higher interest rates. That may still be supportable but make sure to budget out the expected increases in revenue and cost savings (labor, rent, etc.), increases in expenses (feed, inputs) and the debt service for the purchase. As you prepare your budget, make sure to factor in the potential that not everything may go as well as planned and build in cushion for the unexpected events.
Prioritize capital investments. With higher interest costs, we may not be able to make all the purchases that we would like as fast as we may have previously planned. We want to make sure that we maintain capacity for critical needs (milking parlor updates, facility improvements, feed mixers, etc.). You may need to delay replacement of other items that are not as high-use. Land purchases, in particular, can have a large impact on planning with higher land values and interest rates.
Use caution on loans with prepayment restrictions. We can’t predict with certainty, but there are expectations that rates could drop back in the next few years if the economy slows further and inflation is curbed. We continue to encourage fixing rates on equipment and real estate to offset the risk of further rate increases in the near term. But be cautious in using loans that don’t allow prepayments or conversions if rates do come down in the future. Controlling the short-term costs while maintaining flexibility to reset in the future may be the appropriate strategy today.
Interest rate increases this year are significant and do have an impact on the cost for financing capital investments in the upcoming year and beyond. With that said, we are in better financial position as an industry to handle this swing in interest rates. From a historical perspective, today’s rates are still manageable and there is potential for rates to settle back in the future. We may need to extend out our timeline for major purchases, but we should feel confident continuing to invest in our dairy business with well thought out planning and budgeting.
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