The availability of credit is an integral part of the agricultural production process. Borrowing large amounts of capital and incurring considerable debts in order to operate and maintain a farming operation has become a custom practice of the industry. Even though obtaining a loan is common among farmers, the borrowing process can be unclear at times. In an effort to bring clarity to the lending system, agricultural lending firms and banks have attempted to standardize the lending structure. These institutions began classifying loans according to the purpose for which the loan had been obtained and the source of collateral being secured by the loan. Accordingly, there are two types of agricultural loans, “production loans” and “capital loans.”

There are several sources of capital for agricultural producers. These sources include commercial banks, insurance companies, equipment manufacturers, seed companies, cooperatives, processors, the Farm Credit System, and the Farm Service Agency. The largest agricultural lender is the Farm Credit System (“FCS”), which was created by Congress to provide farmers with a reliable source of agricultural credit. The FCS is a nationwide network of privately-owned banks and associations that offer short- and long-term loans to agricultural producers. The Farm Service Agency (“FSA”) also serves as a large source of agricultural lending. The FSA is an agency within the USDA that administers the federal loan programs for farmers. These loan programs assist farmers who do not have sufficient financial resources to obtain a conventional commercial loan. For more information about the FCS, FSA, and agricultural credit, visit the Center’s Finance and Credit Reading Room.

Production Loans

Production loans are granted to a farmer to finance the production of a particular commodity. Normally, production loans are self-liquidating, meaning the loan is repaid from the proceeds of the sale of the particular crop or livestock it was made to finance. Thus, production loans are short-term, usually for a single production cycle. The due date for the repayment of the loan, generally referred to as the maturity date, is typically set to coincide with the date the farmer will receive payment for the commodity.

Because these loans are intended to be repaid from the proceeds of the commodity, a creditor will take a security interest in the commodity being financed. A security interest is an interest held by a lender in property that has been pledged by a debtor. This interest allows the lender to take possession or sell the property if the debt is not repaid. For example, suppose a farmer obtained a production loan from a bank to plant crops. When the bank supplys the funds, the bank will take a security interest in the crops to ensure repayment of the production loan. Lenders will also commonly take security interests in farmer’s crop insurance proceeds to serve as secondary collateral to further secure the production loan.

When a producer seeks a production loan, the lender will consider several different factors before deciding whether to loan the money. Unlike other loans, lenders of production loans are specifically interested in the projected cash flow. In this case, the projected cash flow would be the profitability of the commodity that the farmer seeks to finance. While other lenders will take prior financial history into account, production loan lenders focus heavily on whether the particular crop the farmer wishes to finance can foreseeably be sold at a price that will provide a reasonable opportunity for a profit.

Another factor important to financing a production loan is the type of operation the farmer has. Production loans are used for numerous agricultural operations, and lenders classify loans by the type of farming operation. For example, a loan granted to a commercial feedlot will differ from a loan awarded to a livestock breeding operation because the main source of repayment for the breeding operation is the successful reproduction of livestock. Because the source of repayment depends on different factors under both loans, lenders apply different standards when structuring, granting, and managing production loans.

Many farmers will rely on production loans because the funds are essential for each production cycle. However, these loans are perhaps the most volatile form of agricultural lending. This is primarily due to the fact that the commodity being financed may not produce a profit. Because repayment of a production loan is dependent on successful crop production and marketing, farmers may face danger if their crops are destroyed or the market prices take a sharp decline. When crop loss or price decline occur, the farmer may be left with no option other than to default on the loan. If crop insurance serves as secondary collateral for a production loan, the insurance proceeds will go directly to repay the debt. Consequently, a producer may incur extensive carryover debt into the next production season, which can prevent them from gaining further financing.

Lenders also face risks when granting production loans. Much of the litigation involving production loans arises from disputes concerning which lender gets paid first from the proceeds of the financed commodity, often referred to as intercreditor disputes concerning priority. This issue may arise, for example, when a lender grants a production loan to a farmer for 2020, and takes a security interest in those crops grown by the farmer. The farmer never repaid the loan, and worked with a different lender for the next crop season, who then took a security interest in the crops grown by the farmer in 2021. At this point there is a question of which lender has priority to the crop proceeds. Lenders must be aware of the possibility that other creditors, such as landlords, input suppliers, and service providers may claim a stake in the profits from financed commodities.

Capital Loans

Capital loans, also referred to as operating loans, are granted to producers for non-production purposes, such as financing supplies, goods, machinery, and equipment necessary for the farming operation. Rather than repaying the loan solely from the proceeds of a particular commodity, the primary source of repayment for capital loans comes from the profits generated from the entire farming operation over a period of time.

Because capital loans finance different assets than production loans, agricultural lenders weigh different factors when deciding to grant a farmer a capital loan. Lenders financing capital loans are primarily interested in the financial history of a farmer’s operation. In deciding to grant a capital loan, a lender will review an operation’s profits and expenditures from prior production periods. Also, a lender will likely consider a farmer’s projected income for the operation. Like with production loans, lenders will classify the operation the farmer is seeking to finance according to the type of farming operation it is in order to ensure that the loan is handled properly.

The risks associated with capital loans are largely similar to production loans. Farmers risk defaulting on the loan, and a lender’s priority in the collateral may be challenged by another creditor. However, capital loans are not considered to be as volatile as production loans. Unlike production loans, capital loans usually do not require repayment within a single production cycle. This enables the farmer to repay the loan from income derived from the entire farming enterprise.

Also, different loan structures are available for capital loans. For example, loans for general operating expenses may be due within 12 months or when income is projected to be available. Loans for equipment may be long-term, requiring repayment in specific incremental payments over a period of years. Overall, the structure and repayment terms of the loan largely depend on the type of operation being financed and the purpose of the loan.

For more National Agricultural Law Center resources on finance and credit, click here

For more National Agricultural Law Center resources on secured transactions, click here