When I first started in financial services, most Canadian banks had a domestic bias to their operations. The four traditional pillars of financial institutions were: banking, trust services, insurance, and investment dealers. Traditionally, nearly every large bank in Canada was set up to accommodate these four distinct pillars. Today, these pillars look a little different; some have strengthened, and others have weakened. While Scotiabank’s operating model still includes four pillars, or business lines: Canadian Banking, International Banking, Global Wealth Management, and Global Banking and Markets, these pillars are broader now and structured to accommodate the global landscape.
Similarly, financial services provided by financial institutions have also changed significantly over the years. For example, if a client required money in the past, we would discuss options that are very different from options offered today. Below are a few examples comparing the past along with more commonly used lending options today.
Save until you have enough money
Going back a few decades, many individuals would not venture into investment (financial and non-financial) activities without being able to put the full amount down. This was in a generation when interest costs were very high and new opportunities were not as expensive. Today, any new business venture, or real estate purchase, typically involves some form of debt as interest rates are considerably lower. We are also finding that our clients are comfortable taking on good debt for opportunities to achieve their financial goals. By “good debt” we mean debt that can potentially increase your income, net cash flows, and overall wealth. Debt does not have the same negative connotation that it did in the past.
Years ago, we had the option of setting up a pledge agreement on the investment account(s). If our clients needed a loan, they could sign a pledge agreement and essentially assign the securities/investments within the investment accounts as collateral. We rarely do any pledge agreements these days. The set-up costs are high and better options are usually available.
When investors set up a regular investment account, they have the option to have a margin agreement added to the account if suitable for their investor profile. Margin enables the investor to borrow money against the investments in their account. The total amount they can borrow will fluctuate every day, based on the value of the holdings and cash balances in the margin account.
We do not recommend margin accounts for any of our clients for a variety of reasons. During favourable times when the markets are doing well, the strategy can be useful. However, during unfavourable times when there is more volatility and decline in the stock market, it can cause a serious set-back financially. As markets decline, so does the ability to utilize margin.
Clients who face a margin call must either deposit additional money quickly or be forced to sell securities at lower costs. The interest rate on margin accounts is also considerably higher than other structured forms of debt. If clients want to use leverage for investing, then having a structured debt facility with a financial institution will almost always guarantee a lower interest rate than a margin account.
When we establish a discretionary managed account under the Managed Portfolio Program (MPP) they will always be set up as regular accounts. The regulators have fortunately, and correctly stated, that a Portfolio Manager cannot use their discretion to put clients into a margin situation.
Essentially, buying more securities than the available cash in the account is not permitted. Stated another way, a Portfolio Manager is not permitted to use leverage in a client’s discretionary account. If our clients have lending needs, then we will introduce them to the best option that has the most flexibility and least set up and interest costs.
Unsecured lines of credit
I’m typically not a fan of unsecured lines of credit. First, the unsecured credit line normally has a much smaller dollar amount when compared to a secured line of credit. Second, the interest rates are typically much higher with unsecured lines of credit than with a secured line of credit.
For those individuals who require a line of credit, I would typically avoid unsecured lines of credit. I’ve heard people say they don’t want to put their assets (i.e. house) up as security. My response to that statement is that if you’re planning to pay back the credit line, that really is not a concern.
Often our clients have only a short-term need for financing, usually to facilitate a real estate transaction. Possibly they are upgrading or downsizing their principal residence and the timing of when they sell their home may not coincide with the timing of when they are buying their new home. The bridge loan is a short-term financing option for homebuyers who want to close the purchase of their new property before closing the sale of their current property. If the completion date for the property you are buying is before the completion date for the property you are selling, then you will have to require some short-term financing. With the bridge loan, you can use the equity in the current property as security, borrow money and apply this toward the new purchase, legal fees, real estate commissions, land transfer taxes, etc.
If you have two signed agreements, then obtaining bridge financing is a relatively straight forward process. The interest rate for bridge financing is typically prime plus five per cent. If prime is currently 2.45 per cent, then bridge financing would be 7.45 per cent. This rate is significantly higher than a normal mortgage; however, if the time frame is short then the prorated costs are minimal in the scope of achieving your real estate goals. For example, let’s say you need to borrow $1,000,000 for three weeks. If a typical mortgage rate is 1.50 per cent. The bridge financing rate of 7.45 per cent is 5.95 per cent more than a typical mortgage. If we multiply the 5.95 per cent x $1,000,000 x 21 days / 365 days, then the additional interest costs are $3,423.29. In talking to clients, I explain that this is a fair bit of work for the bank to assist you for only 21 days, and the additional interest costs are essentially the compensation they will receive. The nice part about the bridge financing option is that you will not have a registered mortgage on your property. This is assuming that you do not need a mortgage on the new property as well which can happen if you are upsizing, for example.
Home equity borrowing
Going back to my earlier days in financial services, our clients who wanted to borrow money would typically have a more stringent “income” test to pass. The thought back then was that if you did not have sufficient income flow to repay borrowed money then that was typically an obstacle. Although income is certainly a main factor still for banks to consider, this obstacle can be overcome more easily if you have equity already in your home. Home equity borrowing enables individuals to refinance their existing home (typically the credit limit is up to 80 per cent of the appraised value of your home less any existing mortgage, if applicable).
For example, if you had a house valued at $1 million with no mortgage, you could refinance this home up to 80 per cent and use this $800,000 (80 per cent of $1 million) in capital for other purchases. I have had clients take out equity to purchase a second home, to help children buy a home, and for timing differences when upgrading or downsizing their principle residences when the timing does not match up (i.e. buying new home before selling existing home). This process works fine provided that the underlying asset you are refinancing is your principal residence or real estate that is easy to have appraised.
Many of our clients own a diversified mix of assets, including their primary residence and other assets, such as a vacation property, rental real estate (duplexes, triplexes, etc.), commercial real estate holdings, insurance policies, ownership in small businesses, etc. These clients often have a significant net worth but have more difficulty than they should obtaining lending facilities through the traditional channels. They also have advanced lending needs from time to time, and require a little more service.
Today, for these clients, private banking services are often the solution. This service can encompass many of the features discussed above. For example, a private banker can factor in investment holdings, value in a life insurance policy, etc. when setting up a loan arrangement. A set-up fee is required for private banking, but with that comes considerable flexibility to repay or draw upon when needed (up to established limits), for those clients with advanced lending needs.
A Portfolio Manager’s role is to be aware of both our client’s investing and lending needs. Managing cash flow is a key component to managing overall risk. Although we do not directly assist with the lending side for our clients, we can point them in the right direction of who they should speak with.
Kevin Greenard CPA CA FMA CFP CIM is a Portfolio Manager and Director, Wealth Management, with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week at timescolonist.com. Call 250-389-2138, email firstname.lastname@example.org, or visit greenardgroup.com.