Give people enough line of credit and they'll hang themselves with debt.
The bad boy of borrowing products – that's the line of credit. Recently, the federal government asked the banks to stop blithely handing out home-equity credit lines to people. In his new book The Wealthy Barber Returns, David Chilton writes that credit lines can be an excellent financial tool for disciplined people. "The other 71.9 per cent of Canadians, however, should be careful. Very careful."
Debt is never more comfortable than it is with the line of credit because money is instantly accessible and the rules for paying it back are slack. You can't ignore a credit line, but you can stretch repayment out indefinitely. And then there's the rising interest rate risk. Lines of credit are floating rate debt, and that means you'll pay more every time rates edge higher.
Here are some tips for managing a line of credit from Stephanie Holmes-Winton, who as president of The Money Finder trains financial advisers to address their clients' debt problems:
1. If you're bad with debt, a line of credit won't save you
Ms. Holmes-Winton says she used to advise people with high credit card debts to switch to a credit line where the interest rate is vastly lower. What she found was that these people simply went and ran up the credit line balances.
"I might as well have been blindfolding these people, spinning them in a circle, handing them a Skilsaw and then wondering why they cut their finger off," Ms. Holmes-Winton said.
2. Your LOC is not an ATM
Ms. Holmes-Winton has come across people who take out $100 here and there from their credit lines to help them make it through the week. That's called living beyond your means. You end up with an amorphous mass of debt racked up for purchases that brought only a moment's satisfaction.
3. Beware the LOC-dependent lifestyle
Having a permanent balance on your LOC is an admission that you can't afford your current level of spending. Even if the payments are affordable, they're burning up money that could be used for savings or other more productive purposes. "What I don't want people to do is get in the habit of paying $10,000 down on their line of credit, and then racking it back up again by $10,000," Ms. Holmes-Winton said.
She sometimes suggests people take advantage of the comparatively low cost of a credit line to pay off debt at much higher interest rates (credit cards are the classic example). She says that 10 years is the maximum timeframe for getting this line of credit debt paid off. Smaller purchases, say $5,000 or less, should be paid back in 24 months or less, while 48 months is realistic for purchases in the $10,000 range.
4. Turn your LOC into a loan
Home-equity lines of credit often allow you to divide your borrowing into different chunks, or sub-accounts, Ms. Holmes-Winton said. To impose some discipline in repaying a line of credit debt, ask your lender to set up automatic monthly payments to a sub-account that combines both principal and interest. Set the payments so you'll have your debt paid down over a set period of time.
5. Plan for higher interest rates
Credit lines are priced off the prime rate, which today is 3 per cent. As recently as 2006-07, the prime sat around 6 per cent. That's the background for Ms. Holmes-Winton's suggestion that people estimate whether they can afford to carry the current balance on their LOC at double today's rates.
6. Don't buy a car with your line of credit
People with small credit lines may find that the cost of buying a car uses up too much of their borrowing room, Ms. Holmes-Winton said. Also, adding the car to a bunch of other debts on the credit line can slow the repayment process. "It's very easy for the lines to get blurry. We end up paying for these cars for 12 or 15 years and we can't even tell when we've fully paid for them."
7. LOCs can be a lifesaver
Ideally, you won't buy things until you've saved enough money to pay cash, Ms. Holmes-Winton said. "That works with maybe a new sofa or redoing your bathroom for aesthetic reasons, but it's not the same reality as if you have a leak in your bathroom that you must fix."
In money emergencies like this, a LOC is the smart way to borrow. If you can handle it, that is.
Home equity vs. unsecured lines of credit
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Your home secures your debt
No collateral pledged
Your bank's prime rate in rare cases, or prime plus 0.5 or 1.0*
Prime plus 1 to 7 percentage points or so
You can pay interest only on a monthly basis
Usually a minimum of 2 or 3 per cent of your balance per month, or a minimum dollar amount
Can cost several hundred dollars to cover legal and other fees
Can be up to 80 per cent of the equity in your home
Typically much less than home equity credit line
*the prime rate is currently 3 per cent