Day 3: loans and security

This lesson covers the words on a loan, and the numbers a bank uses to judge it.

Loan words

Principal. The amount borrowed. Principal repayments reduce the loan balance. Interest is what the lender charges you for using the money.

Term loan. A set amount borrowed for a set number of years, often to buy land, machinery or stock.

Principal and interest. Each repayment covers the interest and pays off some of the principal, so the balance falls over time. A loan like this is also called amortising.

Interest only. For a set time, you pay just the interest. The balance doesn't fall. Repayments are lower, but you aren't paying the debt down.

Security words

Security. What the lender can call on if the loan isn't repaid. It might be land, machinery or stock.

Mortgage. A legal charge over land. It gives the lender the right to sell the land if the loan isn't repaid. It is the most common security for a farm loan.

Guarantee. A promise by someone else, often a family member, to repay your debt if you can't. Anyone asked to give one should get their own legal advice first.

Valuation. A qualified valuer's view of what a property would sell for. Banks lend against the valuation, not the price you paid.

The bank's ratios

A ratio compares one number with another. Banks set their own limits, so there is no single pass mark.

LVR (loan to value ratio). What you owe against what the security is worth, as a percentage.

Interest cover. How many times profit covers the interest bill. It is usually EBIT divided by interest.

Debt service cover. How many times the cash the business earns covers interest and principal repayments together. It is a stricter test than interest cover. Banks work it out in different ways, often after taking off drawings and tax.

Equity ratio. Equity divided by total assets, as a percentage.

Covenant. A promise in your loan agreement, such as keeping interest cover above a set level, or sending accounts by a date. Breaking one can give the bank extra rights, so know what yours are.

Where to start

Find the farm's facility letter. Read the limit, rate and security for each loan, and look for the word covenant. Then work out the LVR yourself.

Our bank ratios page shows how each ratio is worked out. The borrowing capacity tool gives a rough idea of what a farm could borrow. Our guide to farm loans covers each type of loan.