Securing credit in a rising-rate environment

With interest rates likely to rise further in the coming months, some financial institutions may be more reluctant to lend, believing some borrowers might struggle to keep up with monthly payments.

If your clients need to access credit in these conditions, a good first step is for them to keep their credit score in good standing and limit themselves to one or no more than two credit cards, said David Field, a Mississauga, Ont.-based CFP and certified cash-flow specialist.

But what about clients who need credit for a large upcoming expense? Advisors and their clients may need to get creative in brainstorming strategies to access credit.

Clients who are looking for a mortgage might consider a re-advanceable mortgage, said Scott Cordier, a CFP with OpenDoor Financial in Toronto. Such a product essentially divides the mortgage into two components: the mortgage loan and a line of credit.

With each mortgage payment, the client gains access to credit equal to the principal portion of that payment. So, Cordier said, if the client makes a monthly payment of $2,000, of which $1,000 goes toward the principal, the client’s line of credit increases by $1,000 with that payment. On a $500,000 mortgage, the mortgage balance will eventually reach zero, and the client will have a $500,000 line of credit.

The client wouldn’t owe $1,000 as soon as it moves to the line of credit, Cordier added. They would only owe it if they used the $1,000 and repay it.

“Your access to credit increases every time you make a mortgage payment,” Cordier said. “That can be very advantageous to those people who need that source of credit.” To qualify for such a mortgage, the client should have at least 20% equity in the home.

Cordier added that the interest rate on this type of line of credit is usually prime, or prime plus 0.5, because the loan is secured by the house. However, since the rate is floating, it will increase as interest rates rise.

Cordier said advisors and the institutions providing these products must educate their clients about their pros and cons, as well as how to use them responsibly. In 2017, the Financial Consumer Agency of Canada flagged re-advanceable mortgages as “complex” products, adding that risks include over-borrowing, debt persistence, wealth erosion and uninformed decision-making.

Cordier agrees with those risks, adding that it’s the individual’s “personal decision and their responsibility” to use and manage such products properly.

“They have access to that equity. They have access to borrow that money. And if they choose to live an extravagant lifestyle, then that is a problem,” he said. “They’re going to have to make those payments at least to service the interest. If they can do that and it’s not a big issue, then great. If they are responsible and using the line of credit for a home renovation, then they [may] have newfound equity inside their house.”

Clients are not just contending with higher interest rates; they are also dealing with inflation. In the current inflationary environment, “cash is really important,” Field said.

“With rising inflation, the general rule is you don’t want to be in cash, because real return is negative,” he said. “But, it’s a lot less risky than falling stock markets and falling bond values.”

Also, cash gives clients access to more credit, he added. “The more cash you have on hand, the less you have to borrow.”

While credit cards have always charged notoriously high interest, other forms of debt remain attractive, even in a rising-rate environment.

“If your line of credit is now 5%, it still looks a lot better than your credit card,” Field said. He noted the strategy of consolidating high-interest credit-card debt on a lower-interest line of credit.

“But, big picture, if you’re not paying that back and you’re racking up more debt, your line of credit is now increasing. If you have debt in multiple places, it’s going to be even harder. It’s all dollars in, dollars out,” he said.

Field suggested some clients should consider cutting back on expenses and reconsider extras such as a second car. Reducing expenses can help enable clients to set aside some cash.