For the most part, 2001 was a profitable year. Milk prices were generally strong, feed was quite affordable, and interest rates dropped substantially over the last half of the year.
Having come off a good year, many dairy producers probably have some cash that they need to put to use. Some will hold this cash to pay bills in 2002. Others will use it to either make purchases or to make down-payments on the purchase of machinery, cows, land or other farm investments.

A third group of producers will make pre-payments on existing term debts for machinery, equipment or cows. Retiring debt will strengthen their balance sheets, decrease future interest expense, and increase their earnings potential. However, unless done correctly, pre-payments to a term loan also can result in future cash-flow problems.

Know the terms of pre-payment
Say a dairy producer borrowed $100,000 to purchase equipment one year ago. Under the terms of the loan - five years at 8 percent interest - the producer agreed to make five equal annual payments of $25,045.71.

After the first year's payment, the loan balance is $82,954.29. The producer has an extra $20,000 that he wants to pre-pay on the loan. After that payment, the loan balance becomes $62,954.29. The savings in interest generated by the pre-payment is $1,600 the first year.
However, cash-flow problems can arise if the repayment schedule is not adjusted after the pre-payment. The lender may require the producer to adhere to the original repayment plan. In this case, the producer would still have to come up with a payment of $25,045.71 at the end of the second year, even though he had 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 above example, the loan balance after the pre-payment of $20,000 is $62,954.29. With just four years remaining on the original repayment period, the new annual payment would be $19,007.37. (See the charts below.)

Under the new repayment plan, the producer is now only expected to make annual payments of roughly $19,000, versus $25,000 as originally agreed. This $6,000 reduction in the annual payment represents the cash-flow savings that the producer gains from making a $20,000 pre-payment on the term loan. In addition, the producer reduces the total interest paid over the life of the loan, and the lower repayment schedule makes it easier to stay current on the loan - especially if milk prices fall and cash flows get a little tight.

Before you make a pre-payment on a term loan, ask your lender if he will reduce the future annual payments. If a lender won't reamortize the loan, think twice before making a pre-payment. You may need this extra cash in a year or so if incomes fall and you're still expected to make higher payments to your lender.

Bruce Jones is a professor of agricultural economics and farm management specialist at the University of Wisconsin.