Why cheap credit is a financial planning problem


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How would a rising interest rate environment affect your customers? The first group to consider would be retired clients who live on a fixed income dream (think: an 8% return in yields on treasury bills and certificates of deposit, last seen in the 1980s). While they may wait awhile to reap the benefits, an immediate and greater concern is those customers who gorge themselves on cheap credit and owe a great deal. You can offer advice to these investors.

What’s the problem?

Years ago, debt was often fixed rate. Mortgages are a good example. This was bad for the banks in a rising interest rate environment, as a 6% 30-year mortgage is worth less when new mortgages are written at 8%. If banks have to mark their assets in the market, it hurts their balance sheets. The solution was to switch to variable rate loans. Your Home Equity Line of Credit (HELOC) is a good example. The rate is prime plus something. Whether interest rates rise or fall, the bank always earns the premium it charges.

This is catastrophic for clients in a rising interest rate environment, as the interest rate charged to them immediately increases when the Federal Reserve raises its rates. This affects customers with HELOCs and revolving credit card balances.

Consider the following example: your client has accumulated a debit balance of $ 500,000 on their HELOC. They couldn’t tell you how, but a new roof, kitchen renovation and some unforgettable vacation played a part. When the prime rate is 3.25%, their bank can charge 3.25% interest. Besides the main part of their monthly payment, they pay $ 1,354 in interest.

Suppose interest rates increase by 2%. If the prime rate is now 5.25% and your bank charges the same amount, their interest payment component becomes $ 2,187. Have they budgeted for this additional expense? Probably not. Fortunately, the interest paid is tax deductible, up to certain levels.

Credit cards are a bigger version of the same problem. Your bank may determine the interest rate as the prime rate plus 14% or 17.25%. If they have $ 30,000 in credit card debt, that monthly payment of $ 431 (interest) increases to $ 481 if interest rates rise 2%. It is worth adding that interest on consumer debt is not tax deductible.

Your client may have a margin loan on their investment portfolio. This can 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 functionality (a checkbook), they may ignore taking out a loan when they exceed their free cash balance. Currently, the interest rate on margin loans is 5.25% as of 12/02/21. You can see the problems if interest rates rise and those increases are passed on to the investor immediately.

Margin loans present an additional problem. The potential to make more money when inventory increases is offset by the liability of the customer’s assets being responsible for all losses when those inventory decreases. In other words, the loan doesn’t go down until you pay it back. All the pain of market downturns is borne by the customer. It can also trigger a margin or maintenance call, since your client is required to keep their equity at a certain percentage. Fortunately, the margin interest paid is considered an investment expense and is deductible.

How to advise your client?

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

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

2. Know what you owe and what it costs: This can be a touchy subject, especially if the spouses do not share the financial details. Everyone should be aware of what is going on because the problem is only getting worse. A good way to streamline it is to think about your federal income tax return. If both parties sign it, both parties have a right to know what is in it.

3. Trim the sails: Imagine your client’s investment portfolio as a three-masted sailboat. It can go very quickly when all the sails are out and there is a strong wind. This is the ideal outcome for your client in a rising stock market. Now imagine this ship with all these sails when a hurricane hits. The ship is in serious danger and can be thrown against rocks. On hearing that a storm is coming, the first steps would be to step aside and dismantle all those sails, making the ship as small a target as possible. The storm is a bear market. The sails are the exposure of the customer’s margin loan. The ship is their investment portfolio. In other words, pay off the margin debit by adding cash or selling securities.

4. Switch to fixed rate loans: Suppose your client cannot 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. It develops its own repayment plan since it is a term loan and the monthly payments are made up of principal and interest. The checkbook goes away.

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

6. Go with cash: This is a contrarian strategy. Are we not moving towards a society without cash? Isn’t payment by smartphone our next step? A big downside is that money becomes abstract. You sign a check or tap your card. You don’t realize what things cost. Need an example? You probably have EZ-Pass on your car. You travel on bridges and toll roads. Do you know how much they cost? You have no idea. Give yourself a reasonable weekend allowance to dine out and be entertained. Take it out in cash on Friday. Pay your bar bill, restaurant bills, and mall purchases in cash. When you physically handle money, it can dampen your impulses.

If your client has a lot of variable rate debt, you might have a big problem. You can help them get past. Can we end with a joke?

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

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

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