A line of credit (LOC) is a debt facility that provides flexibility to access funds quickly, up to an established, approved limit. Having a line of credit can be a great planning tool for future emergencies where you might need access to cash. LOCs are one of the cornerstone components for our clients whether they are working or retired. Below are a few of the elements to understand when considering a LOC.
Secured versus unsecured LOC
Banks will typically offer a secured line of credit and an unsecured line of credit. A secured line of credit is where the financial institution lending you the money will want security for the amount they are lending you. This security is often referred to as collateral. An unsecured line of credit is when you do not have to put up a specific asset as collateral.
One might initially feel like the unsecured line of credit is a better option as you do not have to put an asset, such as your home, up for collateral. There are two important factors to consider when making a choice between a secured or unsecured line of credit. An unsecured line of credit will always have a higher interest rate than a secured line of credit – the difference can be substantial. The second factor is the specific dollar amount that you want to get approved up to, which is referred to as your credit limit. The dollar amount will be lower with an unsecured LOC. In some cases, individuals may not qualify for an unsecured LOC. Certainly, if you want the largest approved credit limit, then a secured LOC is the best option.
Business and personal LOC
Most financial firms have a small business department that helps business clients obtain a business LOC. The security on the LOC will often be linked to assets of the business. Nearly all our clients have a personal LOC in place – the majority of which are secured. For purposes of this article, we will focus on personal LOCs.
Home Equity Line of Credit
The most common form of security for a personal LOC is the home you live in. It is for this reason many lenders will have a term called “Home Equity Line of Credit”, or HELOC for short. Financial firms may have a set-up fee to establish a HELOC. This fee would cover the costs of appraising your home and administrative work to do the credit facility documentation (i.e. registration with land titles). In some situations, and depending on your other banking services, a financial institution may choose to waive these costs, or have a reduced fee.
Knowing your limit
We always recommend our clients apply for a LOC while they have the cash flow to qualify. Assuming the cash flow is sufficient to service the debt, many clients have asked what they typically would qualify for. The general rule of thumb is you can refinance up to 80 per cent of the bank assessed value of your home; however, only 65 per cent of the home’s appraised value can be used for “revolving credit” in the form of lines of credit (HELOC), or credit cards. The remaining 15 per cent must be a fixed loan, like a mortgage. The bank assessed value of the home is not the B.C. property assessment value, but rather a separate appraisal done by the financial institution.
To illustrate, if a client has a home worth $1.2 million dollars, then they could qualify for a total of $960,000 in financing, made up of a $780,000 HELOC ($1,200,000 x 65 per cent) and a $180,000 mortgage ($1,200,000 x 15 per cent).
Many people will go through the process of getting approved for a LOC as a safety net. They don’t plan on immediately utilizing the LOC but want to set it up for emergencies or other purposes in the future. In many cases, our clients have these set up and they are not utilized. There is no cost for an unutilized LOC. If you do not advance funds from the LOC, then there are no costs. From this standpoint, it is a cost-effective safety net.
One of the benefits of a utilized LOC is the ability to do interest only payments. The interest only payment is the minimum required payment. On the flip side, you have the flexibility to pay 100 per cent of the balance outstanding at any point in time. With a traditional mortgage, there is less flexibility. Normally with a mortgage, they will limit the repayment privileges to 10 or 20 per cent of the original mortgage amount, without penalty.
Deductible versus non-deductible interest
On March 19, we published a column, “Structuring debt so a greater portion is tax deductible”. Scenario two in this column provided an example where an individual was co-mingling deductible (business) and non-deductible (personal) transactions. Here is an excerpt:
Dr. Wilson has a professional dental practice with significant real estate holdings. He also enjoys travelling.
A few years back, Dr. Wilson established a line of credit that was used for a mixture of business and personal purposes. Initially, he took the line of credit out to assist him with a couple of his real estate holdings, especially the one that required a new roof. Since that time, he has used the line of credit to renovate the office, fund the family vacation to Italy, and provide an interest only loan to his son to purchase a vehicle.
Our recommendation: We suggested a meeting with Dr. Wilson’s accountant and banker to separate the one line of credit into three lines of credit as follows: business, personal, and son’s loan. Once this was established, we recommended Dr. Wilson focus on paying off the principal relating to the personal line of credit first. The reason for this is that interest costs relating to this personal portion are ineligible and not tax deductible.
Dr. Wilson should make interest only payments on the business line of credit until the personal line of credit is fully paid off. We also recommended isolating the amount relating to the son’s loan so it can be tracked. Separating lines of credit will make it easier come tax time for the business. If Dr. Wilson had not separated the lines of credit, then principal repayments would likely be applied proportionately against the eligible (corporate) and ineligible (personal) portions. It would also be a continuous accounting headache that he would likely have been charged extra to sort out each year.
Sometimes the solution is knowledge — many of our new clients did not know that the bank can establish more than one line of credit, so certain components of your debt can be isolated.
Establishing more than one LOC
Even if you have no interest costs that are deductible, we have advised many of our clients to set up more than one line of credit for certain transactions. As an example, we have a client that wanted to help one of their three children purchase a home. The child was short $80,000 for the down payment and the parents chose to set up a separate LOC and advance these funds to their adult child for the purpose of purchasing a home. The understanding with this transaction was that the parents had a really good rate on the LOC and that the child would pay the interest costs on the LOC, and when possible would be able to chip away at the capital. The parents added a codicil to their will that stated that this LOC would be factored into any estate distributions, if not fully repaid, to ensure equality with all three children.
Time horizon factors with LOCs
Time horizon risk is the risk that the period you planned on holding your investments for becomes shortened, and LOCs can be a useful tool in managing this risk. By utilizing a LOC, you may not have to sell your investments at an inopportune time in the market cycle, or be forced to sell investments with significant capital gains, thereby triggering unwanted tax consequences. A LOC can provide the funds you require in the short-term which, in turn, reduces your time horizon risk. If you anticipate not being able to pay back your debt within a short period of time (under three years), you likely will be better off with having a fixed loan, such as a mortgage, because the interest rates are lower than with LOCs.
Things to consider with LOCs
Prior to setting up a HELOC, I always advise clients to consider a few things. The first, is that there is a small discharge fee if you ever want to close the HELOC. Although you may have the costs to set it up waived, or reduced, there will be a cost to close it one day. Currently, the fee at Scotiabank is $104.95. The bank is required to complete the paperwork to remove Scotiabank as a charge on title. This is only a one-time fee in the future (when the HELOC is no longer needed) and the benefits outweigh this small future charge. The second is a possibly higher annual home insurance cost. From our experience in speaking with insurance account managers, individuals that do not have any debt on their house, and no HELOC set up, or credit facility, attached to the house, can request a discount to be applied. On the last client that I inquired about this for, the agent advised me that the premium for the upcoming year would be $1,534. This client had an unutilized HELOC. This client was told that the insurance premium would decline by $148 if the HELOC was closed – nearly a 10 per cent annual insurance savings.
Use caution when closing LOC
My advice to anyone who has read the above paragraph, and wants to close their LOC, should do so with caution. If you do close the LOC and then want to set it up in the future, you may not qualify as the financial institution has to approve the LOC based on how you can service the debt based on cash flow, not net worth or the home value. As noted above, in the “knowing your limit” paragraph, the limits are assuming you can service the debt on cash flow. If you have retired and have no significant cash flow, then you may no longer qualify for the same LOC amount.
Most of the couples that we work with have a joint LOC. They jointly own their home and they jointly set up the LOC as part of the HELOC. When talking to clients about risk management and estate planning, we will touch on the LOC if this is a component of the plan. Every financial institution is different, but you should understand what happens with the LOC upon the first passing. At Scotiabank, if there is a joint account holder and the loan to value (LTV) is under 65 per cent, then they would allow the surviving spouse to maintain the LOC. If the LTV is over 65 per cent, then the LOC must be closed as part of the estate settlement process.
For most of our clients, the goal is to stay in their home as long as possible. Some are fortunate to have lots of equity outside of their home. Others are house rich, and investment poor. Provided you can get past the concept of having debt linked to your home, the LOC is a fantastic vehicle to enable you to stay in your home longer and have a comfortable retirement. Often the LOC strategy involves a specific meeting with our clients to discuss and review in conjunction with a completed financial plan.
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.