LINES OF CREDIT FASCINATE ME. While normal folks enjoy watch- ing their favourite TV shows, hitting the theatre for a new blockbuster or reading a bestselling novel, I like studying how and why people take on debt.
No wonder I live alone. Pathetic.
That admission aside, lines of credit (LOCs), and the way Cana- dians have embraced them, really are interesting. Some experts describe them as “very helpful.” Others label them “insidious.” How can they be both?
Well, let’s start at the beginning — what exactly is an LOC? It’s a pretty basic concept, actually. It’s an arrangement where a financial institution agrees to lend money up to a specified limit to a customer. Borrowers can use as much, or as little, of the available amount as they want, when they want. What’s more, there aren’t usually any rules that dictate how the funds must be deployed. Plus, with the majority of LOCs, the repayment schedules are non-existent. Clients can pay back the money “whenever” and, in many instances, make interest-only pay- ments each month. For consumers, this keeps the loans’ servicing costs way down. Finally, most LOCs, because they’re secured by the borrowers’ home equity, offer very competitive interest rates.
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What’s not to like? All of these features make lines of credit very flexible and give almost complete control to the customers. Therein lies the problem.
In essence, lines of credit are like giant credit cards but with much lower interest rates and no travel points. And like their plastic cousins, LOCs allow us to mindlessly give in to tempta- tion and live beyond our means.
In the hands of responsible, disciplined and thoughtful borrow- ers, a credit line can be an excellent financial tool. The other 71.9 percent of Canadians, however, should be careful. Very careful. People have gone wild with these things over the last two decades. Can’t afford something? No worries, just “throw it on the line of credit.” I have friends who treat their LOCs like a second income. Others, when they first set up their lines of credit, spend as if they’ve won the lottery.
Even some of my financially responsible colleagues have built up huge balances on their credit lines, half the time without fully realizing it was happening. Hence the earlier descriptive, “insidious” — beguiling but harmful, intended to entrap. It’s not hard to see why so many Canadians have fallen under the spell of lines of credit. The combination of interest-only monthly payments and all-time-low borrowing rates has made credit lines seem almost like free money.
Last year, I was helping a woman who had some financial ques- tions and she mentioned that she had borrowed $60,000 against her LOC to renovate her sons’ bathrooms. (yeah, I know what you’re thinking.) “Don’t worry about that,” she assured me. “The reno only costs me $150 a month. I can afford it.”
Only $150 a month? That can’t be right, can it? Her LOC’s rate was three percent and three percent of $60,000 is $1,800 a year or $150 a month. That’s only $5 a day.
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While doing that math, the thought, “Hey, I want a line of credit for $60,000, too,” danced through my head. Man, these things really are beguiling — they’re sucking me in even as I write a piece warning against them. I’m like the Crown attorney who falls for the beautiful murderess he’s trying to prosecute. OK, that’s weak — but, seriously, an LOC is hard to resist.
So why fight it? Well, let’s go back to the woman’s claim that the reno costs her only $150 a month. Wrong. Very wrong. It costs her $150 a month plus the $60,000!
She conveniently forgot the principal repayment. Her bank, rest assured, will not. She will have to pay it back someday. And that’s a lotta moolah. Even if she tries to spread the repayment over five years, it will still cost her $1,000 a month in principal payments alone. Discharging the loan won’t be easy.
Many borrowers’ answer? Don’t pay it back, just leave it there indefinitely. Worry about it later…much later…in fact, maybe the ultimate later — at death. Essentially, a good number of Canadians are taking on homemade, quasi reverse mortgages. They’re borrowing with a secured line of credit and, sometimes consciously, sometimes unconsciously, planning to pay it back from either the great beyond or when they sell their homes and move to more humble dwellings.
Something tells me this situation isn’t going to have a happy ending. The last thing we need is a nation of people carrying sig- nificant debt loads into already insufficiently funded retirements. And what happens if interest rates go up? Or perhaps I should say, what happens when interest rates go up? We’re not going to be living in an easy-credit environment forever. At 3 percent, all this borrowing is manageable. At 7 percent, it’s tough. At 11 percent, buy some canned goods and head for the basement — we’re in big trouble.
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Those legitimate warnings aside, lines of credit can be a wise choice when financing is needed. I’m not saying that just to sound balanced, either; they really can be.
For example, if you’re borrowing to invest, an idea we’ll explore later, an LOC can play a helpful role — flexible and efficient. If you’re consolidating or refinancing debt, a line of credit is ideal — flexible and efficient.
Again, though, for those prone to overspending (and that’s most of us!), credit lines are a willing accomplice — flexible and efficient.
Their strength is their weakness. They are very helpful, yet insid- ious. ’Twas the best of products. ’Twas the worst of products. you get my point. They’re a financial paradox.
So exercise extreme caution. And when drawing from your line of credit, always remember this incredibly basic but ultra- important fact: It’s not your money, it’s your bank’s.