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Why Cheap Credit is a Financial Planning Concern


As the end of the year approaches, it's a good time to review your clients' financial planning portfolios. As you consider ways they can improve their situation next year, Bryce Sanders recommends looking for those clients who took advantage of cheap credit. They'll be heavily impacted by rising interest rates.

Dec 13th 2021
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How would a rising interest rate environment affect your clients? The first group to consider would be retired clients who are living on a fixed-income dream (think: a return to 8 percent yields on Treasury bonds and Certificates of Deposit, last seen in the 1980s). While they may wait some time to reap the benefits, an immediate and bigger concern is clients who gorged on cheap credit and owe a lot. You can offer these investors advice.

What’s the Problem?

Years ago, debt was often fixed rate. Mortgages are a good example. This was bad for banks in a rising interest rate environment because a 6 percent, thirty-year mortgage is worth less when new mortgages are being written at 8 percent. If banks need to mark their assets to market, it hurts their balance sheet. The solution was to transition to floating rate loans. Your home equity line of credit (HELOC) is a good example. The rate is prime plus something. Regardless of whether interest rates rise or decline, the bank still earns the premium it’s charging.

This is catastrophic for clients in a rising interest rate environment because the interest rate they are charged rises immediately when the Federal Reserve raises its rates. This affects clients with HELOCs and revolving credit card balances.

Consider the following example: Your client has run up a $500,000 debit balance on their HELOC. They couldn’t tell you how, but a new roof, remodeling the kitchen and a couple of vacations of a lifetime played a part. When the Prime Rate is 3.25 percent, their bank may be charging 3.25 percent in interest. Not counting the principal part of their monthly payment, they are paying $1,354 in interest.

Suppose interest rates rose by 2 percent. If the Prime Rate rate is now 5.25 percent and your bank is charging the same, their interest payment component becomes $2,187. Have they budgeted for that added expense? Probably not. Fortunately, the interest paid is tax deductible, up to certain levels.

Credit cards are a magnified version of the same problem. Your bank might determine the interest rate as the Prime Rate rate plus 14 percent or 17.25 percent.  If they are carrying $30,000 in credit card debt, that $431 monthly (interest) payment rises to $481 if interest rates rise by 2 percent. It’s worth adding that interest on consumer debt isn’t tax deductible.

Your client might carry a margin loan on their investment portfolio. This might be part of their investment strategy, if your client understands the benefits and risks of leverage. If they have a securities account with cash management features (a checkbook), they might be unaware they are establishing a loan when they exceed their available cash balance. Currently, the interest rate on margin lending is 5.25 percent as of 12/2/21. You can see the problems if interest rates rise and those increases are immediately passed on to the investor.

Margin loans come with an additional problem. The potential to make more money when stocks rise is offset by the liability of the client’s assets being liable for all the losses when those stocks decline. Put another way, the loan doesn’t get smaller unless you pay it down. All the pain of market declines is borne by the client. This can also trigger a margin or maintenance  call, since your client is required to maintain their equity at a certain percentage. Fortunately, margin interest paid is considered an investment expense and is deductible. 

How Should You Advise Your Client?

When it rains, it pours. Rising inflation has often been bad for the stock market. If your client owes lots of money everywhere, this could be the perfect storm. Here’s what to tell them:

1. Stop spending: Okay, it’s easier said than done. But if big projects and expensive vacations can be postponed, that’s a good start;

2. Know what you owe and what it costs: This can be a touchy subject, especially if spouses don’t share financial details. Everyone needs to be aware of what’s going on, because the problem only gets bigger. A good way of rationalizing it is thinking about your federal tax return. If both parties sign it, both parties have a right to know what’s in it.

3. Trim the sails: Imagine your client’s investment portfolio as a three-masted sailing ship. It can go really fast when all the sails are unfurled and there’s a strong wind. That’s your client’s ideal outcome in a rising stock market. Now imagine that ship with all those sails out when a hurricane hits. The ship is in serious danger and can be thrown against rocks. Upon learning a storm is coming, the first steps would be to get out of the way and take down all those sails, making the ship as small a target as possible. The storm is a bear market. The sails are the client’s margin loan exposure. The ship is their investment portfolio. In other words, pay off the margin debit by adding cash or selling securities.

4. Move to fixed-rate loans: Let’s assume your client can’t easily find $500,000 to pay off their HELOC loan. The same bank that gave them the loan will likely give them a fixed-rate mortgage for the same amount. This develops its own repayment plan since it’s a term loan and the monthly payments are principal and interest. The checkbook goes away.

5. Consolidate those credit card loans: These should be your client’s primary debt reduction focus. It’s their highest interest rate debt. If they have the cash, they should pay them off starting with the highest interest rates. A second strategy is paying them off using their HELOC before converting it to a fixed loan. The third strategy is shopping around for balance transfer offers and cards with a lower interest rate. They can consolidate, then focus their efforts on paying off those cards. Cutting up most of them is a big part of the solution.

6. Go with cash: This is a contrarian strategy. Aren’t we moving to a cashless society? Isn’t paying by smartphone where we are headed next? A big drawback is money becomes abstract. You sign a check or tap your card. You don’t realize what things cost. Need an example? You likely have EZ-Pass on your car. You travel on bridges and toll roads. Do you know what they cost? You haven’t a clue. Give yourself a reasonable weekend allowance for dining out and entertainment. Take it out in cash on Friday. Pay your bar bill, restaurant bills and purchases at the mall with cash. When you physically handle money, it can rein in your impulses.

If your client has lots of variable rate debt, a big problem may be looming.  You can help them get in front of it. Can we close with a joke?

Q:  How many psychiatrists does it take to change a light bulb?

A:  Just one, but the light bulb really has to want to change.

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