Line of Credit – The Upside and Downside

 

Have you ever tried something only to discover later that it wasn’t suitable for you? Imagine a relaxing game of golf, a sweater fashioned in trendy colours, or mouthwatering, savory lobster. You may not feel the same about certain activities or things as your friend.   There is truth in Paul Alessi’s words. “There are two sides to every story.”

Depending on the story, situation, or product, you are likely to lean heavily one way or the other. You either like it or you don’t.  You prefer the upside and don’t see any downside. If you are optimistic, you see only the bright side and avoid the dark side.   

Such is the case with the various loan products on the market.  Loans have two stories, advantages and disadvantages. Different loan products are created specifically for different needs.  The features and benefits of a Line of Credit (otherwise known as a revolving loan) are designed to accommodate unique circumstances.  

 

THE UPSIDE

A “Line of Credit” is different from your traditional loan in such a way that you can access “borrowed cash” at any time for any purpose.  Like a credit card, a specific limit is assigned with a Line of Credit, allowing you to draw down to the limit.

These loan products are becoming incredibly popular. Having a Line of Credit is convenient for you and your loan officer.  Instead of running to the bank every time you need a loan, you make an application only once for a Line of Credit.

One major benefit is the interest is calculated daily only on the outstanding balance. You are only charged interest on the amount of money used. If you dip into your Line of Credit two days prior to payday, then interest is charged only for those days. Generally, the interest rate with a Line of Credit is lower than any credit card, saving you money on interest charges.   

Another benefit most people appreciate is that, unlike a credit card, you are not required to make specific payments monthly.  The monthly interest charges are billed against your available balance. However, the expectation is that deposits are made regularly to ensure the account revolves and is used appropriately.   

This pool of readily available cash can be accessed for any purpose at any time. When emergencies occur, you may suddenly find yourself in a pinch. It’s an acceptable practice to use someone else’s cash to pull you through a rough spot.  The question to ask yourself is whether you can become too dependent on a Line of Credit.  Even with a lower interest rate, the interest costs on a Line of Credit add up to a significant amount over an extended period of time. You may discover you are regularly touching the bottom on your limit.



Bank Statement - Line of Credit

 

THE DOWNSIDE

Lines of Credit can certainly be a security blanket when your emergency savings are inadequate to cover your present situation.  

The upside obviously spoke about convenience. We live in a world where “instant results” have become an expectation. Having access to credit for expenses or purchases is a privilege.  We shouldn’t take advantage of credit for every desire because one day we may find ourselves in financial trouble when we have overextended the boundaries.  The blog, Choosing Your Debt Wisely, proves how debt can quickly become out of control.      

As previously mentioned, one attraction of a Line of Credit (LOC) is the interest rate. Compared to a credit card or payday loan, the Line of Credit interest rate is lower than these two.  Take another step and secure your Line of Credit with property. The interest rate is reduced further simply because your promise to pay back the money is pledged by an asset, something you own.  The security can either be your home, vehicle, or investments.  You declare, “I solemnly swear to pay back every penny, and if I don’t, you may take my house, car, boat, and my children.” (I’m kidding about the children.)  Don’t overlook the risk you are taking when you pledge security.

The downside to becoming too dependent on Lines of Credit is that we never see the light, the bright side of being debt free forever.  Lines of Credit are loans.  Borrowed money eventually has to be paid back. As long as we are working and have the means to pay back borrowed money, everything rolls along until the income stops.  Job layoffs, sudden illnesses, and disabilities can interrupt a steady income. The inability to pay back the Line of Credit can suddenly mean financial devastation. 

Be wary of the convenience and low interest rate that a Line of Credit claims to offer.  It’s true that interest is calculated daily only on the amount you use; however, the financial damage occurs when you compromise security for convenience.  This loan product disguises borrowing money for purchases with a convincing argument that a Line of Credit saves you money.   Home equity loans allow the equity in your home to be used for other purposes: debt consolidation, home renovations, investment opportunities, and vehicle purchases.   The intent with this type of loan product is to simplify your life by combining your income and debt under one roof (one account).  You may be convinced the true intent is to lower your borrowing costs.  That’s a good point but you must know and trust yourself. Although this loan product and strategy may work for someone, it’s not necessarily the right product for everyone. Your responsibility is to fully understand the product and match the right one to your needs.

 

THE BRIGHT SIDE

Remember we know our spending habits.  Sometimes, we have a tendency to believe that if we have money available on our Line of Credit, we have cash but these are two different animals. Credit is not cash.

When I had a Line of Credit attached to my chequing account, I constantly did the math.  I calculated how much I could spend before I hit the limit.  That kind of wrong thinking left me frustrated. I finally recognized the craziness in my logic.  If my account was into my $1,000 Line of Credit by $956.55, I believed I had $43.45 in my account.  Seriously? I was in debt $956.55.  Nothing could change the math. For me, the worst part was seeing a negative balance all the time.  I always felt broke.   Then, I opted to replace my Line of Credit with a revolving loan product separate from my chequing account.  I preferred regular payments which ensured my loan would be eventually paid.  The best part was seeing the positive balance in my chequing account, even if it was only $1.

If you are disciplined, then you have no worries.  If you’re not disciplined and are madly in love with the Line of Credit product, I often recommended attaching the credit limit to a separate account, apart from your active chequing account.  Then you can apply consistent payments to the outstanding loan balance with the intention of eventually paying off the debt.

The secret is in knowing whether you can trust yourself with the freedom to have an endless amount of credit (not cash).  Your responsibility is to learn and understand the different loan products. With the right advice, you can match the right one to your needs.  Managing your debt responsibly is one sure way to live a worry-free lifestyle.

Choose Your Debt Wisely

 

Sinking into Debt

Sally graduated with a practical nursing diploma and currently works at a local city hospital.  Over the course of the two-year education program, Sally accumulated $30,000 in student loans. She currently rents an apartment for $1,200 monthly; her utility bills consist of the usual: power, cell phone, and cable. Now that Sally has completed her studies, she decided to purchase a new car for $35,000.  At Christmas time, she and a friend felt the need to escape the cold winter to a warmer climate.  They booked a trip to Hawaii for two weeks.  Sally didn’t have any savings for her vacation.  She charged all the expenses: hotel, airfare and meals, to her credit card.  All the quaint clothing stores had offers too good to resist.  Sally splurged another $1,000 on clothing.  Her credit card now totaled $10,000. Sally convinced herself she deserved this vacation because she worked hard on her studies. She declared this holiday as her graduation present.  Can you see the trend? 

This fictitious incident can easily happen.  Although you may think I am picking on “Sally,” the female gender, men are as guilty of getting carried away with their spending.  So imagine if Sally meets Harry who has spending habits like hers.  They decide to buy a new home and furniture, continue to take annual vacations, and replace their vehicles every second year.  The debt keeps escalating until suddenly their finances seem out of control.  

Pace Yourself

Keeping a watchful eye on debt is not only a smart strategy but also a responsible one.  Debt payments should only account for 20% of monthly income even though lenders permit up to 40%.  In the blog, Borrowing Money is Like Jumping Hurdles, you were shown how to calculate the TDS (Total Debt Servicing) ratio in order to determine your present ratio.  This information helps you understand the guidelines.

I can’t blame you for wanting everything.  Life is meant to be enjoyed.  Owning a beautiful home, travelling to far-off places to escape the winter blues, and planning your dream wedding may only be a few of your goals. You can’t run a 10km marathon in 10 minutes, why would you expect to have and do everything in 10 years when you have a life-time?  P-A-C-E yourself to avoid throwing yourself in a pool of debt and drowning as a result.        

Beware of Sharks

Choosing your debt carefully is like watching for sharks when you are fishing. You can easily get swallowed-up in debt payments.  Beware of obvious signs.

A relentless retail market constantly bombards the public with attractive advertising.  Seeing ads to finance a new fridge and stove @ 0.00% for the first 18 months is very common. Protect yourself by carefully reading the advertising materials, all disclaimers, and sales agreements.

When contemplating a home purchase, I suggest “playing house”. This sounds a bit unusual but in reality considers all the purchases which come with the title of being an official home owner.   Additional appliances or furniture may be required.  Quite often additional expenses like property insurance, taxes, the extra utility bills like energy, water and sewer are forgotten in all the hype. Then don’t forget the lawn mower and gardening tools!

While considering a new vehicle purchase, think of the payment term in months, not years.  We convince ourselves that five years is not a long time simply because counting to five can be done on one hand.  Remember five years (5) is the same as sixty monthly payments (60) or one hundred and thirty (130) bi-weekly payments. Other life events can happen in five years which may also require money to finance.  Falling in love with a new vehicle is romantic until the payments begin.  Vehicle insurance, license registration, fuel, and oil changes also need to be considered.

The smartest strategy is to eliminate one debt before taking on a new one.  For example, before considering a new vehicle purchase, focus on paying off the student loan.   Whatever you have been driving until now obviously works. If your vehicle is in dire need of repair, at the very least, look for a good used vehicle. The concern is that accumulating payments bring accumulating stress.   Avoid this road as much as possible. 

How to Avoid Drowning in Debt

Financial planners can’t stop anyone from borrowing money for the things they want. However, we can make you aware of the dangers. Your income is like a blanket which is intended to cover all your needs: lifestyle, savings, and debt obligations. Someone (or something) could be left out in the cold if your income isn’t able to do this. Do your homework first before you decide to take on debt.     

The word “old-fashioned” applies to many things: clothes, names, and lifestyle.   Although things do become outdated, many things done the old-fashioned way can still work today.  Our ability to save for the things we want is one of those things.  Rather than save, many now resort to the use of “credit.”  The secret to avoid the debt trap is to start doing things the “old-fashioned” way. Although having a mortgage against a home is acceptable for the purpose of owning a home, continually using home equity for vehicle purchases or credit card consolidation is not.  Choose your debt carefully.  Doing things the old-fashioned way may not be such a bad idea.   

The Credit Counselling Society provides a list to alert people to the typical warning signs of debt that might be out of control. Click here to check their list.         

Borrowing Money Is Like Jumping Hurdles

 

 

Imagine yourself seated across the desk from a loans officer, waiting anxiously to hear the verdict.  Will your request for a loan be approved?  Initially, you felt confident and now you have doubts.  What exactly is the loan officer analyzing?

The credit process can be likened to jumping over hurdles.  As you jump through the following points, you get a sense of the criteria the loans officer puts under the microscope to analyze whether you qualify.  

Hurdle #1: Your Credit Report.  Your credit report will be your first means of defense.  If you have always consciously made your payments in a timely manner, meeting all your loan obligations, then you should have no concerns.  Quite often, people don’t realize what’s involved in maintaining a healthy credit report.  To ensure you understand your credit report and credit score, click here for additional information from Financial Consumer Agency of Canada.  If your credit score is low, you can improve this by implementing some sound strategies as shared in the previous blog, Protect your Score.

Hurdle #2.  Capacity to Make Payments. You can be assured your income plays a significant factor in determining whether or not your loan is approved. Capacity is measured by using ratios: Gross Debt Servicing (GDS) and Total Debt Servicing (TDS).  These are math calculations to ensure your debt payments don’t interfere with your ability to manage day-to-day living expenses.   

GDS focuses on your ability to meet shelter costs, rent or mortgage payments.  That’s all it does.  Generally, when applying for a mortgage, this ratio is used to measure your ability to manage payments.  The amounts factored into the calculation are: mortgage payment (including principal and interest), property taxes, and heating costs.  If the mortgage is for the purchase of a condo, then 50% of the condominium fees are also included.  Once these amounts are tallied, the total is divided by your gross income and then multiplied by 100 to determine your ratio.  Keep your fingers crossed! The guidelines are 25% to 30% of gross income. (Sometimes 32% is acceptable.) The lower the ratio the better since this indicator measures the percentage of your gross income required to cover shelter payment.  For example, if your ratio is 15%, then only 15% of your total gross income is funding your mortgage/rent payments. 

The formula for calculating GDS is as follows (calculate either monthly or annually):

 

Payment of principal and interest on mortgage                                              + property taxes                                              + heating costs                                              + 50% of condominium fees (if applicable) GDSR =                    -----------------------------------------------------------------------------                                              Gross Income

 

TDS calculates your ability to manage all debt obligations including child and spousal support payments.  For many, the big surprise is the payment amount for credit cards is calculated on the available credit limit, not the outstanding balance.  You may have an outstanding balance of $5,000 but your MasterCard credit limit is $15,000.  Your payment used in the calculations will be $450 (3% of $15,000) since you have access to this credit at any given time.   Because you haven’t used the entire balance today, doesn’t mean you won’t tomorrow.  So lenders realize that if you do, then monthly minimal payments will increase.  Although having access to a high credit limit may be beneficial, the full payment affects your TDS ratio as well as the credit limit is the amount shown as a liability on your Net Worth Statement.  

Since you are aware of the amounts involved in the TDS calculation, tally the total, divide by your gross income, and multiply by 100 to determine the ratio.  Ideally your TDS should be 35% or less.  Some institutions allow a ratio of 40%.  Although your loan may be approved despite your high ratio, you have to consider the financial situation in which you may place yourself.

Here’s a glance at the formula for calculating TDS (calculate either monthly or annually):

 

Payment of principal and interest on mortgage                                              + property taxes                                              + heating costs                                              + 50% of condominium fees (if applicable)                                              + payments on other personal loans TDSR =                   -----------------------------------------------------------------------------                                              Gross Income

 

Hurdle #3: Your Net Worth (Capital).  Another measurement of creditworthiness is your present net worth. When assigning a value to assets such as motor vehicles, snow machines and the like, use realistic values. Do not overvalue them. Vehicles are a perfect example since they quickly depreciate. In reality, question whether someone would be willing to pay this amount for a particular asset. 

To help create your Net Worth Statement, click here to use this on-line calculator. Once your statement is created, liabilities are subtracted from assets. If your liabilities are greater, then your negative net worth is alerting your loans officer to a potential problem.  Generally, the one exception for showing a negative net worth is if a student acquires debt in pursuit of an education. Technically, as a student, you are an asset with the ability to generate an income to pay off your student loans. 

 

Assets Everything You Own	Liabilities Everything You Owe
Net Worth (Assets – Liabilities)

 

 

Hurdle #4: You (and Your Character).  It’s about you.  Attitude is everything.  Attitude shows up in your credit report, your ability to be employed, and in your conversation with your loans officer.   The important question to answer is: Will you uphold your promise to repay the loan? As time goes on, you accumulate a history which will follow you.  Establishing a strong relationship with your loans officer will be important.  Over time, you, no doubt, may require more than just one loan. 

 

Hurdle #5:  Collateral.   The reasoning behind using collateral to secure a loan is assurance that some or all of the money can be retrieved if you happen to default on your loan.  So many unforeseen events might occur to cause you to miss payments and neglect your financial obligations. Eventually, the only recourse remaining for the lender is to sell your asset to repay the loan.  Whether you assign your car, investments, or house, as collateral, you pledge a promise to pay back the debt. In the event you don’t, then the asset will no longer be yours.  When examining all the criteria to approve your loan, collateral generally would be the last consideration.

 

How does everything look as you jumped over the hurdles?  This information cracked open the door to the credit assessment process. Everyone’s borrowing needs are different; special consideration is given to special circumstances.  Guidelines are in place as tools to help with the process.  Not only are the financial reports and ratios analyzed but your loans officer also implements good judgment on your behalf.  When you continue to meet your loan obligations consistently over time, you will build both a trusting relationship with your lender and a strong credit history.  This best outcome when borrowing money becomes necessary to fulfill your dreams.