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By JoAnna Pachner
MSN
Wednesday, June 7, 2006
Canadians are carrying on a love affair with credit. Fed by historically low interest rates, the debt-to-income ratio — the key benchmark of our indebtedness — is now at 117%, meaning that for every $100 the average Canadian earns, he spends $117. Where is that extra $17 coming from? Well, there are personal loans, credit cards, mortgages. But the financial vehicle we have most passionately embraced is the line of credit (LOC).
Adrian Mastracci, investment counsel at Vancouver’s ‘fee-only’ KCM Wealth Management, says, “There’s no street corner you can pass that doesn’t have a financial institution advertising lines of credit.”
Canada Mortgage and Housing Corp. (CMHC) has estimated that 208,700 new homes will start going up in 2006, but may revise that forecast upward in light of a surprisingly strong beginning to the year. Nationally, February starts were down about three percent from a blistering January, but still soundly beat expectations. British Columbia saw a 23% leap in new housing starts in urban centres, and Alberta recorded a 19% increase. East of the Prairies, starts dropped in February, but the West’s increases nevertheless propelled the total for the first two months 18% above the same period in 2005. Single-family homes were up 22% while condominiums, town homes and other so-called “multiples” rose 14%.
“There’s no street corner you can pass that doesn’t have a financial institution advertising lines of credit,” says Adrian Mastracci, president of Vancouver-based KCM Wealth Management Inc. “The institutions want to know your income and saving capacity, but it’s very easy to meet the criteria. I don’t know anyone who couldn’t get [a line of credit].
LOC popularity is surging because they’re seductively simple to use, and a bargain to boot. An LOC is essentially a credit account at a financial institution. After paying a modest set-up fee, you withdraw what you need whenever you need, and pay interest — which is typically variable, meaning it floats with market rates — only on what you’ve borrowed. Banks rarely put restrictions how you spend the money, and make it as easy to access or transfer the funds as those in chequing or savings accounts.
Like a credit card, an LOC has an upper limit, and you have to make regular interest payments on the outstanding amount. However, the interest is substantially lower: while credit card rates range from the upper teens to close to 30%, many banks are offering LOCs at prime — currently 5.5%.
“You can make the point that lines of credit are replacing credit cards,” says Benjamin Tal, senior economist at CIBC World Markets Inc. The LOC segment grew 23% last year, he says. Six years ago, it was credit card debt that was rising at 25%; that’s now down to eight percent annual growth.
The most popular type of LOC is the home-equity line of credit. Backed by the consumer’s primary residence, it is also the cheapest because, from the bank’s perspective, it carries the most secure collateral. Such secured LOCs typically only require you to pay the ongoing interest. Unsecured credit lines cost more, but the difference isn’t big: PC Financial, for example, offers an LOC at prime plus 1.25%. You do, however, have to make minimum monthly repayments on the balance (three percent is average), and the credit usually tops out at $50,000.
Consumers tend to set up LOCs with specific expenditures in mind — ones that usually take place over a period of time, such as renovations. Some turn to an LOC to eliminate more expensive debt, paying off high-interest credit cards and consolidating all their debts in one low-interest account.
Mastracci says LOCs offer the biggest bang when used for investment purposes, on the assumption that the cost of borrowing will be lower than the return you’ll see when you invest those funds. What’s more, if that money buys a dividend-paying stock or an equity mutual fund, the credit-line interest would be tax-deductible (provided you hold these investments outside your RRSP).
You could also, as he puts it, “invest in human capital” by tapping an LOC to upgrade your skills in hopes of getting a higher income in return. There are LOC products designed specifically for that purpose. CIBC’s Education Line of Credit offers up to $40,000 to help cover post-secondary education, while its Line of Credit for Professional Students gives those studying the medical professions access to up to a $125,000 credit line.
The growth in LOCs and other consumer borrowing has slowed a bit lately, due in part to the gradual rise in interest rates. “Also, in the past few years the banks have used up the pent-up demand for credit,” says CIBC’s Tal. However, he adds, “to see a significant deterioration in borrowing, we would have to see significant increase in interest rates. And some predict that a year from now, interest rates might actually start to go down.
Still, keep in mind that the flexibility and convenience that make LOCs so attractive can also make them dangerous. As with credit cards, “a lot of people run away with lines of credit and rack them up too high,” says Mastracci. Indeed, a quarter of LOCs are today used for personal spending, be it vacations or home theatres, according to CIBC.
To avoid getting burned if interest rates spike, financial advisers urge discipline. Establish a clear purpose for the LOC and give yourself a firm timeframe for repayment. Also, develop a contingency plan for how you’ll repay the money if an emergency hits. (Some institutions offer insurance to cover LOC debt in eventualities like death or serious illness.) And don’t forget: love affairs rarely end painlessly.
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