Debt management is an essential financial skill for any entrepreneur. The mortgage on any real estate they own is typically the biggest single indebtedness most equine business owners take on (and that real estate may also be the business’s largest single asset). From time to time, it pays to look at the business’s overall debt load and ask if it may be time to refinance.
The most obvious reason to refinance, says Bob Brooks of Horse Country Real Estate in East Lyme, Connecticut, is that there has been a big change in interest rates. If interest rates have dropped dramatically, refinancing can lower your payments and improve the business’s monthly cash flow, or it can shorten the term of the loan so you build equity faster. In the best-case scenario, you can do both. “There are tremendous savings possible over the life of the loan,” he says. When interest rates drop, horse farm owners with an adjustable rate mortgage may want to refinance in order to get the predictability of a fixed rate.
Refinancing can also be a way to restructure the business’s overall debt load, says Stormy Duffey of Farm Credit of North Florida in Ocala, Florida. Since taking out a mortgage, the business owner may have financed a truck and trailer or built a new arena. By refinancing, he or she may be able to roll all of those individual debts into a single payment at a better rate.
Some entrepreneurs grab their credit cards and use expensive short-term financing to add capital improvements such as new fencing or an addition to their barn, says Duffey. Not only are they paying extremely high interest rates, she says, but at tax time they also discover that, unlike their mortgage interest, the consumer interest on their credit cards is not deductible. Refinancing to roll short-term debt into long-term debt can not only save them hundreds of dollars in interest but may also lower their tax liability.
Duffey points out that refinancing also gives business owners a way to tap the equity they have built up in their real estate. Many equestrian businesses are seasonal, for example. They may experience several months of very low cash flow followed by months when the cash flows more freely. A $10,000 or $20,000 line of credit can help them avoid using short-term credit card debt to pay bills during low cash months until cash flow spikes again. If they are 10 or 15 years into their current mortgage and they want to build a new indoor arena or buy more land, it may make more sense to tap into the equity they have built up rather than take out a new loan for the improvements alone.
“Before refinancing, you want to sit down and look at your complete financial picture,” says Duffey. She advises people to sit down with their accountant or financial advisor and discuss their overall debt load, their assets, their cash flow, their tax liability, and the relationship between the amount of debt they have and their goals. That is the most important step in figuring out whether refinancing makes sense.
One of the things your advisors can help you determine is just how long it will take for you to recoup the cost of refinancing. If you are trying to take advantage of a lower interest rate or shorten the term of your loan, says Duffey, “The rule of thumb is that in order to save, you have to have at least a 1.5 point difference in loan rates.” However, she adds, depending on how much you still owe and the length of your mortgage, just a point can make an enormous difference.
For example, she says, if you are 5 years into a 30-year mortgage on a loan of $250,000, can drop a point, and change the loan’s term to 20 years, you probably will not change your monthly payment more than $100. However, you will take 5 years off the time it takes to pay the loan off in full and will save about $100,000 in interest costs over the life of the loan.
Typically, Duffey says, refinancing works best for people who owe $200,000 or more. “If you only owe $50,000 or $60,000, it’s probably not really worth it,” she says. In addition, refinancing is probably not worthwhile if you are not dropping your interest rate at least a point and have not held your current mortgage for at least 3 years. That’s because it takes about three years to pay off a loan’s closing costs.
Duffey cautions borrowers to scrutinize closing costs carefully when refinancing, especially if their original loan was made only a few years ago. “People don’t ask enough questions about who gets various fees and how they can save money on closing costs,” she says. Don’t just show up at closing to sign the papers, she says. Ask the lender to provide a complete list of closing costs in advance, and check it for things like loan origination fees. Ask who gets that money and if the amount is negotiable. If a property survey was done only a few years ago, ask if it can be updated rather than completely redone. You may be able to sign an affidavit saying there has been no change since the last survey and save some money. Similarly, find your title insurance and ask for reissue credit. Reducing closing costs even a few hundred dollars can significantly change the refinancing break-even point.
Who Ya Gonna Call?
Most residential mortgage lenders are not interested in horse properties, says Brooks. After they write loans, they usually resell them to Fannie Mae (Federal National Mortgage Association) or Freddie Mac (Federal Home Loan Mortgage Association) which are federally chartered to buy residential mortgage loans from banks or savings and loan associations and resell them to investors. Fannie Mae, for example, requires that the value of the house be at least 50 percent of the total package. Without the ability to resell the loans, banks may require the house value be up to 80 percent or more. The ratio of the value of their acreage to the value of any residence puts most horse properties out of this residential loan picture.
In 1988, Congress authorized the Farmer Mac program (Federal Agricultural Mortgage Corporation) as the agricultural twin of Fannie Mae and Freddie Mac. Bob Larson, president of Janus Ag Finance, which places agricultural loans throughout the United States from its Littleton, Colorado, headquarters, says that this program has now become the primary source of horse farm loans. These loans are available through agricultural loan brokers like Janus Ag Finance, through rural savings and loan associations with money to lend, and through Farm Credit associations that are members of the Farm Credit System.
Larson cautions that horse business owners should be sure from the start that they are working with advisors and lenders who understand agricultural property loans. It can be heartbreaking, he says, for budding entrepreneurs to think they have financing for their horse property only to see a deal fall through when it reaches the appraisal stage. That can happen when an inexperienced mortgage loan officer doesn’t realize that the amount of acreage involved takes the loan out of the residential mortgage market. Residential lenders typically do not do loans on properties over five acres, says Larson, unless they are in an area where larger acreages are typical and comparables are easy to find nearby.
Larson says that many horse operations fall into Farmer Mac’s part-time farmer program. The value of the house (not counting barns or any outbuildings) must be at least 30 percent of the value of the property and the owner must live on the farm. It is easier to qualify for part-time farmer loans because underwriters will look at other income sources such as an in-town job or a spouse’s income in addition to the property’s business income potential. “By and large, across the country we probably approve 10 part-time farmer loans for every one commercial horse ranch,” says Larson.
Horse entrepreneurs who truly work full-time in their business will need to qualify for a commercial loan if they refinance and that, say both Larson and Brooks, can be hard to do if you are in the horse business. “It’s hard for banks to tell who’s in horse business and who’s playing horsey,” says Brooks. Lenders are tremendously wary of horse business owners trying to turn a hobby into a tax deduction. When someone approaches her for refinancing on a horse property, says Duffey, she wants to see their business plan, where they are in it, and the tax returns and financial statements that back up their claims.
The underwriting guidelines for commercial loans are considerably more stringent than for residential or part-time farmer loans. The right loan ratios (see sidebar) become even more important. The maximum loan-to-value ratio for most commercial loans is 70 percent, says Larson, and lenders want a 1:1 debt coverage ratio or better.
Good property-to-debt ratios are rare for horse business properties close to populated areas, says Larson, because appraisers must look at highest and best use of the land. From an agricultural standpoint, horse pasture might be appraised at $400 to $500 an acre. In a suburban setting, however, land may be valued at $15,000 or more per acre. So a property may appraise at $1 million or more based on its value for suburban housing, while its use for pastures and riding arenas doesn’t justify a value of more than $100,000. When you have expensive land and a $300,000 or $400,000 house, it is hard for the property to generate enough income as a horse enterprise to cover a commercial loan.
However, if the business owners are truly full-time horse people with a successful history of making money on their tax returns, have a solid level of adjusted gross income and can show that they are consistently generating this level of income, refinancing using a commercial loan can work, Larson says.
If you plan to refinance in order to tap into your equity, “Go to a lender before building your arena or making major capital improvements to be sure you qualify for the loan programs,” Larson advises. Proposed improvements can skew the loan ratios and affect your ability to borrow money. Larson cites the example of a couple with 20 acres in the midst of a suburban area with many hobby farms. They built a huge barn with the intent of turning their hobby into a business. Land values locked them out of the residential loan market and their clear commercial intent made it impossible for them to qualify for a part-time farmer loan. They couldn’t qualify for a commercial loan because they had no business history. With a smaller house and barn they might have qualified for the part-time farmer program since they had outside income. Since the big barn was already up, however, they were in trouble.
Understanding the financing available before you expand or change your business can mean big differences in loan rates. For example, Larson notes that the spread on loan rates in April 2004 ranged from 5.34 percent for a 30-year fixed rate residential mortgage to 6.2 percent for a rural housing loan, 6.8 percent for a part-time farmer loan, and 7.5 to 8 percent for a commercial loan.
Ultimately any decision about refinancing should be part of an overall risk management plan for your equestrian business, says Duffey. You need to analyze your reasons for refinancing carefully, be sure that they support the goals set in your business plan, and understand how they are going to affect not only the annual bottom line but also month-to-month cash flow.
Rolling short-term credit card debt into a mortgage to support your lifestyle or buy non-business items like a boat or vacations are not good reasons for refinancing. “That’s a slippery slope to bankruptcy,” says Brooks. Duffey also advises borrowers to finance things for an appropriate term. While 20 years may be suitable for a new indoor arena, plan on a shorter term for financing a new tractor or fencing. If you refinance to get a line of credit, make sure your business plan includes a plan for paying it back down in reasonable amount of time and over an appropriate term. If you use that line of credit to buy a horse for $2,000, plan to add $1,000 of training, and know you can resell it for $10,000, that’s good business, says Brooks. If you buy the horse because its bloodlines are similar to a horse you remember from your youth and you’ve fallen in love with it, that’s not a good business reason.
Like any other choice you make for your business, refinancing should present a serious opportunity for financial gain if it is going to make sense. Run the numbers, then decide.
Getting Papers in Order
When you show up to discuss refinancing, lenders are going to ask you for proof of both business profitability and your personal financial worth. Here is a list of the paperwork to have in order when you sit down across the desk. Your loan officer may ask for others.
- A detailed business plan (covering at least the next 5 years)
- Income tax returns (personal and business) for the past 3 years
- Balance sheet and profit and loss statement for the business for the year to date
- Business cash flow projections for the next year
- Projections for income, expenses and cash flow for the life of the loan
- Personal financial statements (net worth, personal indebtedness)
- List of personal and business assets available as collateral
Loan-to-value ratio. Borrower’s total loan(s) divided by fair market value
Debt Coverage Ratio. Net monthly operating income divided by total monthly debt (less than a 1:1 ratio means a negative cash flow)
Top Debt Ratio. Monthly housing expense divided by gross monthly income
Bottom Debt Ratio. The total of housing expense plus debt payments divided by gross monthly income.
Search for Farm Credit associations by state using the interactive map.
Sites with useful financial calculators to help you figure out how much money you qualify to borrow, when you will reach the break-even point on refinancing costs, and other loan information.
Lists qualifying requirements and loan limits for Farmer Mac loans available through Farm Credit System associations and other lenders.
Farm Service Agency site with general overview of federal loan programs (including disaster relief loans) available to agricultural producers and those living in rural areas.