“I’m an accountant,” Elaine says. She reads this blog. And she worries a lot, mostly about her clients.
“So many clients drowning in debt. Even people who had previously paid off their homes have used their home equity lines of credit to do crazy things like invest in failing businesses, invest in schemes to earn high interest rates with no guarantees and just generally take money out to buy frivolous things like vacations and do home renovations.”
No surprise there, Elaine. Lines of credit, especially those backed by a house, have been the fastest-growing pile of debt for several years now. How much? Currently the banks hold almost $250 billion in HELOC (home equity line of credit) loans. That’s equal to a big 12% of the Canadian economy – compared to just a third as much in the US.
So, just like the Yanks did when their housing market bloated and everyone bragged how much their inflated properties were worth, Canadians are sucking off their equity gains and doing stupid things with it. Like renovating. Or buying a cottage. Or an investment condo. Yup, more real estate exposure. And more debt.
Back to Elaine:
“I had lunch with a fellow accountant the other day and I asked her if she’s seeing this as well in her clients. I was floored with her answer: “Me too! I’m drowning in debt too! I bought my house thirteen years ago for $180,000 and now the mortgage is well over $300,000!” Her house is worth about $400k, so any correction in the market would wipe them out (she’s in her late forties). Hate to say it, but I still have a feeling that the Canadian economy is doomed. Everyone has jumped onto the debt train and there’s no going back now.”
As you know, HELOCs are easy to get. The banks push them hard with rates around 3.5%, and are happy to hand over 65% of your equity. The payments can be interest only, making them cheap to carry. And if you use the money to invest in something paying taxable income, then 100% of the interest-only payments are deductible from your income.
In other words, if you’re sitting on a $1,000,000 paid-for shack in Vancouver, you could borrow $600,000 to invest in a balanced portfolio making 7% (just an example), giving you $42,000 in tax-efficient income, while the annual cost was $21,000, or about $15,000 after the tax break. Of course, there’s risk here. Nothing goes up forever, including stock markets or your house.
Or, you can borrow against your inflated home equity, run up a bunch of debt, and piss it away on a vacation, a boat, or a rental condo on which you’ll have a negative tax flow. This was the American experience – people using houses like ATMs to drain off their boom-market equity gains, figuring real estate values would never dive. They did. You know the rest.
HELOC loans are all variable, and the rate of interest is tied to the bank prime. That, in turn, reflects the Bank of Canada’s overnight rate, which hasn’t budged in a few years. So it’s safe to assume the line of credit cost will remain static for another year or so, as the economy remains somewhat diddled.
But there’s a negative correlation between rates and houses. So when rates rise again (they will, like the sun), real estate prices will fall. This is not a happy thing if you happened to take a lot of equity from your house, for two possible reasons: (a) the bank can call your HELOC because you’ve exceeded the loan-to-value threshold of 65%, meaning you have to cough up all the money you just spent on a Porsche for your mistress or (b) you have to refinance at a higher rate, increasing your debt costs at the same time your house declines.
I’ll bet a lot of the 20% of Canadians who have a HELOC today don’t quite understand the rate isn’t fixed, that higher payments can be demanded arbitrarily, or the credit yanked if your house value falls. And while interest-only payments are sexy, you might end up after years of payments with a debt as big as when you started. Or worse.
Now, a word about GICs. They’re the favourite investment in Canada, and one big reason why most people are going nowhere financially, and have gambled so much on a capricious housing market. Not smart.
To earn 2% at RBC, for example, you must hand over your GIC money for five long years, where it is non-redeemable. If this isn’t inside an RRSP or TFSA, the interest is added to your taxable income and fully whacked at your marginal rate. For most people, this turns the yield into less than 1.5%.
This week we heard the latest inflation news, with the cost of living now rising by 2.4% annually. Hence, GICs suck. Even sheltered inside an RRSP you’re losing money. So why not put the cash into the preferred shares of your bank instead of the bank itself? They are far more stable than common shares, pay about 5%, and do it in the form of dividends – which are taxed at half the normal rate. That boosts the average pre-tax yield to more than 6% – or three times that offered by a pathetic GIC.
Wait! TNL@TB didn’t tell you about preferred shares when you went in to ask about conservative investing? She just put you into a GIC? I’m shocked.
By the way, where do you think the bank gets the money to fund those HELOCs? Uh-huh.