Borrowing basics

  • 4 min read

Perhaps you’re a young farmer borrowing money for the first time. Or, maybe it’s been a while since you’ve applied for a loan and need a refresher. No matter what stage you’re at, there’s always something new to learn.

In this article, we’re reviewing some borrowing basics - what you need to apply for a loan, how much you need for a down payment and tips for choosing the right loan length, interest rate and amortization.

Applying for a loan

Before you meet your lender, you’ll need to collect your financial information. Give yourself time to gather and review all required documents. You should understand your financial statements (beyond how much money you’ve made and your tax situation) and be able to answer any questions to show you know your operation. Here are the key pieces to consider:

Net worth statement: This provides a snapshot of your assets and liabilities. It also shows how you can manage the requested loan. You’ll need one for each borrower involved.

Tax returns and financial statements: Your lender will want to see past income tax returns and any accountant-prepared financial statements dating back three years. It helps them determine if you have the overall financial capability to make the loan payments.

Third-party assistance (for large loans): If you have a complicated situation or are borrowing a sizable amount, it’s a good idea to involve someone like your accountant to help with financial planning.

Tools and ratios: Consider a cash flow analysis, especially if there are times in the year when expenses outpace income. Financial ratios can be calculated to determine the health of a business, which is important for securing a loan. Accounting software like AgExpert makes financial ratios easy to obtain.

Business plan: If you’re new to farming, or if your loan is for a farming enterprise that’s a drastic departure from what you’ve been doing, a complete business plan may be required. 

Identification: If you have off-farm income, bring recent pay stubs or written employer verification. And don’t forget to bring government-issued photo ID to verify your identity.

Down payment

For a land loan, you typically need a down payment equal to 25% of the purchase price. Since that can be a lot of money to come up with, it’s common to pledge other land as security rather than making a down payment. It’s also possible to use a combination of land and cash.

Beginning farmers often have family support and land owned by the family can be pledged instead of the down payment. By becoming a co-applicant, the family can provide support without providing cash. However, they become equally responsible for the loan.

Loan length, interest rates and amortization

Loan length: The rule is to match the loan length to the life of the asset. New equipment, terms of 7 to 10 years, are typical. Used equipment, 5 to 7 years, is standard. For land, loans of up to a maximum of 29 years are possible, but most are in the 20 to 25-year range.

Interest rates: You have choices - a variable rate that fluctuates or a fixed rate that holds for a specified length of time. Note, you might have a 20-year land loan, but only have a term of 5 or 10 years at the fixed interest rate. At the end of the term, the interest rate is subject to change. Historically, the variable rate has often been lower than the fixed rate, but a fixed rate provides predictability.

You can also select the pre-payment provisions that meet your needs. Some loans are open, and you can pre-pay any amount of principal without penalty. You can also choose a closed loan but will be penalized if you repay more than a particular percentage of the principal in any given year.

Amortization: Loan payments are amortized, meaning they’re divided into equal annual payments. However, in the early years, most of the payment goes towards interest, while in the later years, it goes toward principal. The amount of interest vs. principal has ramifications for income tax since interest payments are a deductible expense while principal payments are not. An example of an amortization table is below.

Payment Amount Principal Interest Balance
        $500,000.00
1 $40,330.30 $15,082.94 $25,247.45 $484,917.06
2 $40,330.30 $15,787.30 $24,543.09 $469,129.76
3 $40,330.30 $16,580.70 $23,749.69 $452,549.06
*** *** *** *** ***
18 $40,330.30 $34,778.03 $5,552.36 $74,924.37
19 $40,330.30 $36,537.34 $3,793.05 $38,387.03
20 $40,330.30 $38,387.03 $1,943.34 $0.00

Put your ideas into action

So now that you understand some of the borrowing basics, work on some of the things we discussed to help get you prepared to meet your lender. Here are 5 ideas to get started: