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By Jasmine Miller
National Post Business Magazine
April 2004 Issue
After a run of bad luck, Bob and Helen hope a home-equity line of credit can get them back on track. But will it just handcuff them?
Adrian Mastracci, investment counsel at Vancouver’s
‘fee-only’ KCM Wealth Management, says, “I would caution everyone about using lines of credit as an emergency fund. You have to be aware that there is a possibility that the terms may change even if you are up-to-date and there is nothing wrong with your credit history.”
When Bob and Helen (not their real names) started dating about seven years ago, both were well acquainted with financial calamities. For Helen, now 37, the end of her first marriage eight years earlier had cost her big time: She had to cash in RRSPs to buy out her ex's part of their home ($24,000 for a house they had purchased in 1996 for $265,000). As well, just before she'd met Bob, who is now 46, Helen had launched her own business -- Me Inc. -- giving up a salaried position to work for herself as a beauty stylist. As for Bob, he too had his own business (in real estate), but it was on the skids. Still, their economic tribulations didn't interfere with a blossoming romance, which led to marriage in 1998. Two years later the couple had their first child, now three, but Bob was without work.
Because of that rocky history, they are, financially speaking, like a young couple just starting out: light on assets, particularly with regard to savings. Still, they have a healthy net worth because of their home, which is currently valued at about $450,000 (but with a mortgage of $195,000). "That's the bank's estimate," says Helen. "Our real estate agent thinks it's really worth about $40,000 more than that." While it's only a paper gain until they sell, the equity they've built up in the renovated home, located in the heart of a sought-after neighbourhood in Calgary, could be the answer to their financial problems. If they tap into that equity now, Bob and Helen figure, they may be able to make up for a run of bad luck in the past.
Their financial problems as a couple began in 1996, which is when Bob's business went belly up. After a year of looking for work, he landed a job (in advertising) with benefits, but not before the couple had racked up significant debt. "Slow and incremental is a good way of describing it," Helen says of the mounting credit card charges, which now stand at about $16,000. The family was living off Helen's income and not quite making ends meet. "Then there was a last-minute family function for Bob," continues Helen, "and we had to spend close to $4,000 flying out east to attend that, but otherwise the cards were just used for small things."
Compounding the financial problem is the fact that, as a freelancer, Helen's $60,000-a-year income is sporadic; she can wait months before being paid. "I try to budget for a certain amount of money coming in, say, February, since the invoice was sent at the beginning of January, but the money often doesn't come."
When Bob landed his salaried job ($36,000 annually plus commission), they could finally start to pay down debt and begin to save again -- a good thing since they're becoming increasingly concerned about how to fund their retirement years, though it certainly helps that Bob now has a pension plan to count on. "The window is closing on us," Helen says, referring to their ages and their relatively small $30,000 in RRSPs. "And I feel our priority should be to get cracking."
The first step in restoring their financial health, they decided, was to figure out where their cash was going. Yes, they now have a good household income, but even with that, Bob and Helen still find themselves in overdraft occasionally.
About three months ago, the couple started what they call their "envelope system" of budgeting. They marked a bunch of envelopes with all their regular expenses -- "We tried to think of everything. Like the cleaning lady, groceries, my haircuts," says Helen -- and deposited what they thought was a reasonable amount of money into each one. That amount had to last for the month. "We started to see which envelopes got emptied the fastest," she adds, "and when you start dipping into other envelopes, you know you have a problem." For Bob and Helen the problem areas are entertainment and groceries. "For a family of three, $500 a month is a healthy amount for groceries," she says. "But we'd need to take $4 from other envelopes to buy milk."
Helen's foray into an investment club was covered by the cash in the "entertainment" envelope. That might seem odd, but it makes sense, sort of. "We know exactly what an investment club should be doing in terms of paperwork and research and proposals, and we don't do any of it," says Helen. Instead, the five women get together every month or two and socialize. The actual investment choices are often last-minute decisions, and then "we each write a paltry cheque for $100 or $200," she says. Luckily, they've made some good choices. They bought Nortel when it was $3.15, "figuring it was worth the gamble, and now [at the time of the interview] it's worth $12." Over the past two years there have been other good buys, too, including TD Bank at $27 a share (worth around $44 now) and Estee Lauder at $33 (about $40). "I've quadrupled my money, but even if I cashed out now it would only be about $2,000," says Helen.
After they identified their problem spending areas, Helen and Bob moved on to what they deemed to be the logical next step of the envelope experiment: prioritizing their spending. "We need to start topping up our RRSPs," says Helen, referring to the $15,000 of unused contribution room each has. "And we can't afford that unless we start fine-tuning those envelopes, so we need to figure out how we can find another $200 a month. We need to pull back." One move: Helen took out a small RRSP catch-up loan this year. The $5,000 will be paid off in eight months.
Even without making an effort, their cash flow is set to improve soon. Come September, their daughter will be out of daycare and into kindergarten, freeing up about $300 a month. This summer, the lease on their car is up and they've decided to go for a cheaper model, saving about $100 monthly.
All good moves, but getting rid of that $16,000 credit card debt and the associated 18% interest rate requires a bold move: a home-equity line of credit, perhaps? Bob and Helen have applied for one for two reasons: to transfer their high-interest credit card balances to a lower-interest product; and to pay for a $14,000 kitchen makeover. "I think we should just take the $30,000 we need, but Bob thinks we should go for the $100,000 we qualify for," says Helen, "just so we have it in case of emergency." But should they tap into that nest egg at all? Or are they just mortgaging their future?
"I would caution everyone about using lines of credit as an emergency fund," says Adrian Mastracci, of KCM Wealth Management Inc. in Vancouver. "You have to be aware that there is a possibility that the terms may change even if you are up-to-date and there is nothing wrong with your credit history."
Financial institutions do periodic reviews of your file (they may send a letter in the mail, asking you to update information, or conduct a short phone interview or go over the information when you are in the branch). If your circumstances have changed since you first qualified for the loan -- you've lost your job, for example -- your lender could decide they no longer want you to have access to the line of credit, and recall it. And that defeats the purpose of an emergency fund. Having said that, Mastracci feels a line of credit is a good way for Bob and Helen to cut the interest payments on their debt and work toward building assets.
Shanna Rosen, of Investors Group in Toronto, is more bullish on the strategy. "It's a terrific idea," she says. "Look at the numbers. Let's say they use the line of credit as if it were a loan, with $16,000 to pay the credit card balances and $14,000 for the kitchen reno, and they get an interest rate of prime plus 2% [about 6.25% now]. If they paid $584 a month, the loan would be paid off in five years. They're paying more than that now on credit cards alone."
When it comes to how much of a line of credit to take, Mastracci feels it makes sense for Bob and Helen to go for the maximum of what they qualify for so they don't have to renegotiate -- and possibly incur appraisal fees -- if they need more later. "The only problem," he says, "is, can they resist the temptation to use it? There is an easy-money feeling with home-equity lines of credit, and that can be dangerous." If they use the available funds to buy items with a depreciating value -- holidays or home decor, for example, two problem spots for this family -- they will be right back where they started. It's a cycle most people get trapped in, according to Mastracci. Still, if they're careful, a line of credit could be a good deal for Bob and Helen. They could divide the line of credit between business and household expenses and use it to smooth out their cash flow. "Helen should draw a regular salary from the business portion of the line of credit and pay off the balance with her cheques when they arrive," he says. "They'd save on overdraft interest and possibly non-sufficient fund charges as well."
Continued on page 2
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