Lines of credit: let the good times roll — carefully

The bank lends you what you need as you need it. The trick is to control those needs and most MDs are good at that

By Michael Citrome

No matter how much money you earn, cash flow is always a big issue — after all, even if your salary stays constant, your expenses don't. It's never pleasant to find yourself with unexpected expenses when your well-thought-out budget is already stretched to its limit.

Banks do offer a financial product that can make both budgeting and dealing with the unexpected a much more pleasant proposition — as long as it's used responsibly. For the debt-o-phobic out there, remember, "Line of Credit (LOC)" is not a dirty phrase. Used with restraint it can be the key to really enjoying your earnings on your own terms.

A line of credit is a different beast from the types of borrowing most people are used to — credit cards, mortgages and conventional loans — although it has aspects of all three. Like a mortgage or conventional loan, a line of credit has a competitive interest rate and can be for a large sum of money, even over a hundred thousand dollars. Like a credit card, you only borrow as much as you need but unlike a mortgage, there's no fixed payment schedule though there's a minimum monthly payment required. If you want to pay off more at any time you have the cash, there's no penalty. In other words, a line of credit is flexible.

And the best part is that a line of credit is incredibly easy to use — you can link it to a credit card, write checks on it, use it to pay with Interac, or withdraw from it at an ATM. The fact that it's a line of credit is invisible to the person you're paying. The one thing you must never forget is that it's all borrowed money.

The interest rate on a line of credit is what makes it especially attractive, both as an alternative to credit cards and as a way to finance major expenses like home renovations.

"Depending on the person's financial situation and collateral, the rate can vary between prime and prime plus 1%, prime is around 4.5% these days," says Michel Mondor, Montreal regional director for BMO Harris Private Banking.

Typically each monthly payment on a line of credit must be 2% of the capital, plus any interest accrued during the month. Unlike a regular loan, you only pay interest on the amount you've borrowed — so if your line of credit has a limit of $80,000, but you've only borrowed $20,000, all you'll have to pay back each month is 2% of what you owe, plus the interest on it. At current rates, that's less than $500 per month.

INTEREST ONLY LOCs
Banks do offer an interest-only line of credit, where you don't have to make capital repayments, but Mr Mondor only recommends those for very specific situations, such as times when you have a lot of expenses but know you'll be getting a chunk of cash very soon, for example from the sale of a property.

The risk, of course, is that because the money is there you'll be tempted to use it. "It's easy access to cash," agrees Mr Mondor, " but doctors are usually quite responsible and able to use this tool properly."

Even if your line of credit is interest-only, you can still pay back as much of the capital as you want at any time. And if you start out with an interest-only line of credit, you can convert it to a conventional capital-repayment line of credit at any time and vice-versa by going to your loan officer with an interim demand. It's easier than it sounds.

One area where lines of credit may not stack up to credit cards is if you religiously pay your entire balance off every month and never run into any interest charges. Lines of credit don't have the grace period that credit cards do — you start paying interest as soon as you withdraw or otherwise use the LOC money.

But if you do run a balance from time-to-time, interest rates on credit cards can be more than triple that of a line of credit — typically 18% and more — and cash advances on a credit card start accruing interest immediately, as do cheques written from your credit card. That's no deal.

You can even use your line of credit to earn Air Miles, and many banks will issue you a MasterCard or Visa that's linked to your LOC at the LOC interest rate. Ask whether the grace period applies.

LEVERAGE HELP
There is one other area where a line of credit can help you out, and that's leveraging your investment portfolio. Basically that means borrowing money from your LOC for your living expenses and investing your earnings in a way that will earn you a higher rate of return than what the LOC interest is costing you. Sounds complicated? That's because it is — and you'll need an expert to help you out, like a Certified Financial Advisor, a Chartered Accountant or a Quebec Notary.

Mr Mondor says that leveraged loans may be more useful for younger people than those thinking about retirement, and that it's key to get an expert to evaluate your risk. But for riskier borrowing like leveraged and interest-only loans, it's best to know that your income is going to increase, ideally significantly, over time, rather than stay stagnant.

A line of credit may not replace a mortgage or a credit card, but it can be a very useful tool for getting things done now and spreading the payments out over a long period of time.

Sure, you can save up for that in-ground pool with the deck for barbecuing, but at only 5 1/2% interest each year, and the ability to pay off more when your GIC reaches maturity, it can make a lot more sense to get a line of credit and enjoy life now.