How I Use a Line of Credit to Unlock Deferred Income
It’s Friday friends!
The brutal cold has surely hit the bulk of us North Americans — while Texas has been under snow and ice, we Manitobans have had 18 straight days of -30C (and -40C+ wind chills) temperatures. (For my American friends, I learned Fahrenheit and Celsius meet at -40.) We haven’t really ventured outside in weeks, so we’re looking forward to the balmy weather ahead this weekend.
This week, it’s a continuation of this whole “personal net worth” thing. Specifically, how to utilize debt tools to unlock your unrealized gains and non-cash equity. Big words for a pretty easy topic to understand.
Using a Line of Credit to Unlock Deferred Income
Sometimes I get on a path and I have to stick it out until I’ve had my say.
Deferred income is one of those paths.
There comes a time when you leave school, enter the workforce, start a family, perhaps buy a home, and begin the journey to retirement, that you start to see how the puzzle pieces fit together. You may dream as a business student that you will never go into debt to buy that car, or you promise your children will never go through what you had to go through.
And then the time arrives and you realize why you have to go into debt to buy a car or that it’s a good thing for children to have to struggle through things.
More often than not, there’s a reason the path well-travelled is, well, well-travelled.
One of those things, for me, is the cost of living:The cost of waking up in the morning, putting food in everyone’s bellies, paying for the roof over our heads, finding a few pleasures along the way, and somehow still saving enough for the future.
There are many roads to fulfilling these goals, as we’ve discussed countless times over the last few weeks. The path I find myself on is one of deferred income and lesser cash today, but strong savings and more cash tomorrow.
This makes it a little more difficult to put food into bellies and roofs over heads today.
There are tools to offset the liquidity pinch, but you have to use those tools with a great deal of care.
Carefully Living Above Your Means
“Live beneath your means” is probably the most-used statement in Personal Finance. Living beneath your means is the key to financial bliss, they say. Living beneath your means is the key to a healthy life, healthy relationships, and a healthy retirement.
The advice isn’t wrong, of course. But it’s not a magic pill either.
Just like “pay for everything with cash!” can’t fully serve those who earn a bi-weekly paycheque, “living beneath your means” can’t fully serve those with deferred income.
When you map out your financial picture and discover assets growing each day but a bank account balance that dwindles, what are you to do?
In general, I believe people make more money than they think they do. They receive a net paycheque deposited to a bank account and the positives only go up a couple times a month. But that is only a part of what makes their world spin round. Their home value grows, their pension assets grow, and their RESP balances grow for their kids, all of which are going to hit their bank account at some point in the future.
Sometimes, you need to take a loan out from your future self to help pay for today.
Or, if handled correctly, you can use some debt to allow your future to fund your now.
You’ll pay a fee to do this. (It’s called interest.) And it’s not the least risky way of living life.
But tools like lines of credit are there to unlock deferred income. They can help you “live above your means”, if you will.
Remember: We’ve defined your “means” as your income, which includes anything that increases your personal net worth. You could say we're artificially changing your "means" by changing the definition of income.
As long as you keep your wits about your “means”, I believe most people are wise enough to dip in and out of the red and carefully manage asset growth, liquidity, and living life.
The Line of Credit: A Magical Financial Tool
Note the subtitle just above here. “Magical Financial Tool”. I truly believe this, but it’s one of those tools that must be wielded appropriately. Like a really heavy sword, you could end up hurting yourself if you don’t wield it properly.
Lines of credit are low-rate, instant-access, always-on credit tools that enable you to quickly and easily borrow money. Secured lines of credit can range from 2% to 5% and unsecured lines of credit range a bit higher. They are offered like candy by financial institutions and they are tremendously difficult to pay back if you don’t have the discipline.
Lines of credit are a way to dip your toe into the unrealized world of your financial life.
Say your home is worth $300,000 and you have a mortgage balance of $150,000. In Canada, you are allowed to borrow a maximum of 80% of the value of your home. How you borrow can be a combination of debt tools, but many opt for the mortgage + home equity line of credit (HELOC) combination. With the above prices, you could theoretically have a $90,000 HELOC available to use (($300,000 * 80%) - $150,000).
If you borrow some money from that HELOC, you’re basically taking money from the non-cash equity you have in your home. If you view your equity in your home as a savings account of sorts (you should), then by and large, an advance out of the HELOC is an advance out of one of your savings accounts.
But remember: An advance out of that LOC should be considered an advance out of your personal net worth as a whole. You’re taking from yourself (and paying a fee to boot) in order to convert your equity into cash.
That’s where it needs to end — if you reach the point of borrowing money you don’t have (or, read another way, taking cash from a LOC beyond your personal net worth), then I think you’ve gone too far.
If you can find this balance, lines of credit allow you to convert your non-cash equity into a cash form, which unlocks numerous investing opportunities to allow your assets to compound and grow.
Use a Line of Credit for Investments
A sure fire way to use lines of credit wisely is to use them strictly for investment purposes. Borrow money from that LOC if, and only if, you’re buying a growing asset. To me, this can include a variety of assets:
Dividend paying stocks that pay a higher dividend than your interest cost
RESP contributions for your kids that you subsequently pay off throughout the year thereafter
RRSP contributions to reduce your tax bill and move your taxable income from one bracket to the next
Startup costs for a business
I simply don’t think it’s wise to use the LOC for buying clothes, toys, vacations, or vehicles. Vehicles, in particular, may very well be eligible for a lower rate loan at the dealership.
By keeping your LOC for investment purposes, you also unlock tax-deductible interest. If you borrow money to make an investment or to fund startup costs for a business, the interest becomes deductible on your tax return and reduces the real cost of interest by your marginal tax rate (20% to 40% or more). The investments need to stay out of a registered account — you cannot deduct interest on investments made inside an RRSP or TFSA, for instance. But aside from this limitation, this makes an investment-only LOC a fantastical tool — the interest rate becomes 30% cheaper, you have access to instant cash to jump on investment opportunities, and you can pay down the LOC without any penalty.
If you can find dividend paying stocks that pay a higher rate than your LOC interest rate, I think you’ve found the world’s easiest form of arbitrage. (There are lots of great dividend paying companies in Canada. You don’t have to look far.)
I get it — it’s a bit risky to tell people they can live beyond their means. It’s antithetical to the wisdom provided by those so much older and wiser than I am.
But in my years in this industry, the one thing I’ve learned is that people have more than they think they do. People who you’d think have no business retiring are able to retire. People who only make $X,XXX amount of money find a way to afford that specific investment.
Your means are, in fact, greater than you think they are.
Which leads me to the ultimate recommendation:
Nail down your net worth.Understand your sources of income.Budget to meet a specific rate of return each year.Have long-term goals. And keep your eyes on the long-term prize.
Thank you for your time this week. I wish you and yours a wonderfully relaxing weekend and a healthy and prosperous week ahead.