For the most part, 2001 was a profitable year. Hog prices were strong, feed was affordable and interest rates dropped substantially.
Now you may find yourself with cash to put to good use. You may hold this cash to pay bills in 2002. You may use it to grow or upgrade buildings, replace equipment or make a down payment on land or other farm investments.
Another temptation is to make pre-payments on existing term debts for machinery, equipment or seedstock. Retiring debt will strengthen your balance sheet, cut future interest expense and increase earnings potential. However, unless done correctly, pre-payments to a term loan also can result in future cash-flow problems.
First and foremost, know the pre-payment terms.
Let's say you borrowed $100,000 to purchase equipment a year ago. Under the terms of the loan – five years at 8 percent interest – you agreed to make five equal annual payments of $25,045.71.
After the first year's payment, the loan balance is $82,954.29. You now have an extra $20,000 that you want to pre-pay on the loan. After that payment, the loan balance becomes $62,954.29. The interest savings that the pre-payment generated are $1,600 per year.
However, cash-flow problems can arise if the repayment schedule is not adjusted following the pre-payment. The lender may require you to adhere to the original repayment plan. In this case, you would still have to come up with a $25,045.71 payment at the end of the second year, even though you paid ahead on the loan.
The lesson to be learned: Before you pre-pay on a term loan, make sure the repayment schedule will be adjusted. Simply reamortizing the loan balance over the remaining life of the original loan would establish a new, lower repayment schedule.
In the previous example, the loan balance after the $20,000 pre-payment is $62,954.29. With just four years remaining on the original repayment period, the new annual payment would be $19,007.37. (See accompanying charts.)
Because of the new repayment plan, you would see a $6,000 reduction in the annual payment, which represents the cash-flow savings that you gain from making the $20,000 pre-payment. In addition, you reduce the total interest paid over the life of the loan, and the reduced repayment schedule makes it easier to stay current on the loan – especially if hog prices fall and cash flows tighten.
The take-home message: Before making a pre-payment on a term loan, ask your lender if he/she will reduce the future annual payments. If a lender won't rebalance the loan, think twice before making a pre-payment. You may need the extra cash in a year or so if incomes fall and you're still committed to the higher payments.