A line of credit can be a valuable financial planning tool for your clients, particularly at today’s low interest rates. In some cases, an LOC secured by a house can be an even more attractive option than a conventional mortgage, due to the greater flexibility of debt repayment.

“In tough economic times, an LOC is the first thing I would suggest as a source of funds if cash is tight,” says Ted Rechtshaffen, president of TriDelta Financial Partners Inc. in Toronto.

An LOC can be secured or unsecured, depending on the amount, but the interest rates are generally more favourable if the credit line is secured. If a house is being used as security, most banks will offer an LOC that — when combined with the mortgage on the home — can go as high as 80% of the value of the house.

For those clients who have paid down a good chunk of their mortgage and whose homes have increased substantially in value, this could result in a substantial chunk of change in the form of a home-equity LOC (a.k.a. an HELOC).

Some clients may choose to finance their house entirely with an LOC instead of a mortgage. Clients who arranged fixed-rate mortgages a few years ago may find that an LOC, which typically floats just above the prime rate, may actually cost less in interest charges than their existing mortgage.

The best time to arrange for an LOC is when your client doesn’t need it, says Warren Baldwin, regional vice president with Toronto-based financial planning firm T.E. Financial Consultants Ltd.

Typically, banks like to know that debt will be repaid in a timely manner, which means they take a close look at employment history, net worth and ability to service the debt. As such, it’s a useful item to arrange now and have at the ready in case of a future job loss or a decline in income; an LOC is much more difficult to obtain once your client falls upon hard times.

“Banks are careful about the lending process; in their eyes, a client can go from prince to pauper very quickly,” Baldwin says. “One day, somebody can be at the top of their game and, the next day, they are told they aren’t needed anymore and given their bag of cash. If banks see that someone doesn’t have a job, they are reluctant to extend an LOC. Sadly, that’s the time when it can be most useful.”

The interest rate on an LOC depends on the client’s creditworthiness and the type of security offered; it typically ranges from prime plus 0.5%-2.5%. HELOCs offer the best rates, usually only 80 basis points to a full percentage point higher than prime, which is currently 2.25%.

In comparison, the posted rate at Royal Bank of Canada on a fixed-rate, five-year mortgage is currently 5.5%, although discounts are com-mon; a variable-rate mortgage is available for prime plus 30 bps.

It often makes sense to arrange for a higher LOC than needed, although that sounds counterintuitive, as banks frequently charge lower interest rates for higher amounts.

“The LOC is a great tool, and everybody who qualifies for one should get it,” Baldwin says. “There’s a big difference between having access to it and actually using it, but it can be an important part of an overall financial strategy.”

Once in place, an LOC is like a loan allowance that can be drawn upon and repaid at the borrower’s convenience. With an HELOC, as the mortgage balance decreases, the available credit increases in order to maintain the original debt/equity ratio.

Usually, lines of credit are elastic, allowing the borrower to increase or decrease the amount outstanding — as long as it stays within the negotiated limit. Some borrowers may decide to pay interest only on the outstanding balance, or they may set up a structured repayment schedule for all or part of the amount borrowed.

“Clients have the flexibility to use the LOC for whatever they want,” says Bernice Dunsby, senior manager of home-equity financing products with RBC. “But we would caution a client not to get into the habit of just paying the interest and not making a dent on the principal, as the borrowing costs would add up over time.”

@page_break@Clients who have lost their jobs may simply not have the cash flow available to make mortgage payments, which are typically a mix of interest and principal and must be made on a regular basis; in these situations, an LOC can come to the rescue.

If clients have enough room on their LOC to pay off their mortgage completely, they could take advantage of the greater flexibility when it comes to principal repayment. Most banks require interest to be paid monthly on an LOC, but if a client is strapped for cash, even these payments can be added on to the credit outstanding if there’s room.

“If the client had a $300,000 LOC available and has borrowed $200,000, he or she could add the interest payments to the amount. And if that can’t be done automatically, it could be done manually,” Rechtshaffen says. “It’s a stopgap measure that can help a client through a tight spot. To someone in dire financial straights, finding an extra dollar can be huge and can help a family hold on.”

Even if there is a termination penalty for paying a mortgage off early, Rechtshaffen points out, it can be worth it for the relief from regular interest payments.

“Clients who are suffering financially may be concerned about actually losing their home if they fail to meet the mortgage payments, or cancelling their life insurance,” he says. “A penalty of a few thousand dollars today may not mean that much a few years down the road, when the situation has improved. Meanwhile, all has not been lost and the family still has a roof over their heads. A person who was earning $120,000 a year may not get a job for a year; and when they get one, it may be a $90,000-a-year job, but they’ll be able to get back on track.”

For the person who has little financial discipline, this is not a strategy Rechtshaffen would recommend. However, he says, most financial advisors’ clients are focused on financial planning to begin with, and taking advantage of an LOC and a timetable for eventually paying it off can be built into their strategy.

An LOC as an alternative to a mortgage can also be useful for people whose incomes are sporadic, such as those who work in the arts, who are self-employed or who rely on annual bonuses. Unlike a mortgage, an LOC could allow for payments to be deferred in thin times and increased in fat times.

“If the client’s income is extremely variable, an LOC can work better than a mortgage,” says Rechtshaffen. “In a particularly good year, the client could pay off half the debt or eliminate it completely as there’s complete flexibility.”

If a client’s mortgage is locked in at a higher rate than an LOC, Baldwin says, it can make sense to convert part of the mortgage gradually to an LOC. The line can be used to take advantage of annual lump-sum payments against the mortgage that many lenders permit, thereby converting a portion of the mortgage to an LOC each year without paying any penalties.

For example, with a 15% annual mortgage prepayment privilege, a client with a $300,000 mortgage could move $45,000 every year to the more flexible LOC with no penalty. By taking advantage of these allowable prepayments before the end of this year, and again in the early part of next year, Baldwin says, the client could exempt almost one-third of the mortgage from the prepayment penalty.

If the client could slice $90,000 off a mortgage by utilizing an LOC that costs two percentage points less in interest a year, it would save $1,800 a year in interest — with the savings increasing if the client converted similar amounts during the next few years. But if the client employs such a strategy, Baldwin says, it’s important to keep up with the discipline and apply the payments that would have gone toward the mortgage to paying off the LOC.

The risk is that because an LOC is tied to the prime rate, the advantage over a fixed-rate mortgage could disappear if interest rates turn upward, he says: “The client could go from the frying pan into the fire if interest rates rise dramatically, but the feeling seems to be that interest rates are not expected to rise much in the near future.”

Another strategy for using LOCs is particularly useful to clients who come into a lump sum of money — say, through a bonus at work or an inheritance.

Instead of simply investing the money, Baldwin suggests paying down a chunk of the mortgage with the cash, then taking out an equal amount on the LOC and investing it. The interest payments on the amount borrowed would then be tax-deductible, as the tax laws allow for deductibility of interest on loans used for investment purposes.

Non-deductible mortgage debt would thereby be converted into deductible debt. It’s important to track the amount of interest payments on this portion of the LOC carefully, or have a completely separate LOC for investment purposes so that there is an accurate accounting of the interest paid at tax time. In fact, most banks allow clients to divide their total LOC into separate allocations to allow for easier tracking.

“It’s a good idea to keep pure the LOC that is being used for investment purposes,” says Baldwin. “Otherwise, the deductible and non-deductible debt can get all muddled up, and it’s like trying to unmix paint.”

If interest rates stay low, clients shouldn’t be in a big rush to pay off their LOC, Rechtshaffen says, as there could be some other profitable uses for it.

For example, by investing in a registered education savings plan for children, the client could take advantage of lucrative tax credits, which would add up to more than the interest costs on the loan. The federal government also offers a 20% grant, to a maximum of $500 per child, on the first $2,500 of RESP contributions.

If money is tight, an RESP gets additional benefits. Ottawa increases the grant on the first $500 of RESP contributions to 40% for a family whose net income is below $38,832. For families that have net income between $38,832 and $77,664, the grant rate on the first $500 of RESP contributions is 30%. IE