Credit and Debt Management

Most Canadians will incur some form of indebtedness, whether it is in the form of a mortgage, vehicle loan, or credit card debt, at some point during their working lives. Ensuring that debt, and its inherent cost, is minimized before retirement will provide a retiree with a more positive cash flow.

Credit can be defined as a financial transaction that involves the lending of money and the transfer of property with the promise of repayment by a fixed maturity date. The transfer of property in a credit transaction is only intended to be a temporary expedient.

The lender is the grantor of credit, and is known as the creditor. The borrower is said to be the debtor. Credit and debt, and the lender and the borrower are therefore, on opposite sides of the same coin.

Debt is a contractual obligation that is enforceable by law.

The cost of debt is a function of the principal borrowed, the interest rate charged, and the frequency with which the interest is compounded. The interest rate charged by the creditor is the price of the loan and the rate reflects the creditor's risk. Generally speaking, the more frequently that interest is compounded the worse it is for the debtor in terms of total interest costs. Conversely, the more often that interest is compounded, the better the situation from the creditor's perspective.

A consumer can arrange credit so that it is open-ended, closed-ended, secured, or unsecured. Revolving credit is also known as open-ended credit. Under the terms of a revolving credit arrangement a limit is pre-authorized and extended. The consumer determines when and the amount of credit to be drawn, and is only required to pay a minimum amount, usually monthly. In other words, this credit line can be charged up and paid down within the pre-authorized restrictions. Common examples of revolving credit would include credit cards and lines of credit.

Credit also exists in a closed-end form. According to this arrangement, the debtor must pay the principal plus interest according to a pre-arranged and agreed-upon schedule. An example of this type of credit is a mortgage.

Finally, credit can be arranged as either secured or unsecured. Security is usually provided either in the form of collateral or by a specific guarantee. Generally speaking, all else being equal, a secured loan carries less risk than an unsecured loan and therefore a secured loan carries a lower interest rate.

These factors are considered by all lenders, in varying degrees, when they review requests for credit.

Character refers to the borrower's reputation. Researching a borrower's reputation will involve looking at past payment performance and a review of spending habits to date. One important question from the lenders perspective is the purpose of the loan. The lender is concerned with the quality of the loan's purpose; an acceptable purpose for a loan is to borrow funds to buy a home. It might be considered a poor purpose to try to obtain a loan to pay out a bankruptcy debt.

Here the lender is considering the debtor's ability to re-pay the loan and interest in a timely manner. The lender will be interested in reviewing the borrowers continuity of income. Stability of income through long-term employment is desirable. The lender will often perform ratio analysis when determining debt capacity.

The amount of security or collateral that one can pledge to securitize their borrowing, will be a factor when determining the total amount that can be borrowed. Although collateral may make a loan safe it cannot make a loan sound.

Collateral is intended to induce the borrower to be orderly and timely in the re-payment of the loan since collateral is used for partial or full recovery if the borrower is unable to pay the loan according to its terms. Additionally, collateral is required to ensure that the borrower has a stake in the loan transaction.

Some types of collateral are considered better than others from a lender's perspective. Good quality collateral can come in many forms including equity in a home, or financial assets such as guaranteed investment certificates (GICs), Canada Savings Bonds (CSBs), or term deposits (TDs). Poor forms of collateral are personal assets like a stamp collection or jewelry, which have limited resale potential. A guarantor or co-signer who signs on a loan to provide support for the credit is equally responsible for the obligation and the re-payment of all debt. The assets held within RRSPs and RRIFs cannot be pledged as collateral for credit.

A lender is interested in a borrower's ability to repay the loan plus accrued interest in case of any unforeseen circumstances. Common occurrences that may require a capital injection include unemployment, illness, or a marital breakdown. Items that a lender would consider appropriate capital include investments and rental properties. A registered retirement savings plan (RRSP) is considered capital as individuals have saved in order to accumulate this capital sum and in emergency, it can usually be redeemed. It is important to note that liquidating an RRSP will result in lowering net worth, and will incur income-tax withholding remittances.

A borrower's credit history in the form of a credit report is used to evaluate the lender's risk.

The credit report, which is obtained from the local credit bureau, contains such information as the borrowers name, address, age, debts owed, employment/occupation, prior residential addresses and litigation details. Some information such as mortgage debt may not be listed in the credit reports as not all financial institutions share this debt history information with the credit bureau.

The credit bureau's members are area merchants and lending institutions that deal with consumer credit. Members are required to file information with the bureau. In return, these companies can refer to the credit bureau for information, as required. These members usually pay a user fee each time they access the credit bureau database. Since there is a time delay between when creditors report to the bureau and when the credit bureau actually records the transactions to the credit report, the bureau report may be out of date. Dun & Bradstreet produces similar reports for commercial lending purposes.

Danger signals which may indicate credit instability include the inability to meet past payment obligations, credit abuses, an applicant who lives beyond their means, no collateral, pending or prior lawsuits, a loan for a poor purpose, frequent job shifting, numerous inquiries to the credit bureau, frequent changing of residence and any lack of full disclosure to the lender.

Individuals can access their personal credit report by telephoning or visiting their local credit agency or bureau.

The financial terms and conditions of a mortgage contract would include:

• the loan amount,
• interest rate,
• amortization period,
• loan to value ratio,
• term, and
• pre-payment privileges.

Each mortgage is a unique contract negotiated between the mortgagee (lender) and the mortgagor (borrower). It is prudent to review the mortgage contract with a financial advisor and a legal representative (lawyer or notary) before signing the document.

The mortgagee (lender):

• must be sure that the mortgagor holds clear title before the mortgage is arranged,
• must register the mortgage as security,
• must provide the mortgagor with the funds when needed, and
• must provide a discharge of the mortgage loan when certain circumstances arise.

The mortgagor (borrower) covenants to:

• make payments on time,
• pay the property taxes,
• insure the property,
• keep the property in good repair, and
• not sell the property without the mortgagee's written approval.

The loan to value ratio compares the loan amount to the value of the property for which the mortgage is made. A conventional mortgage has a loan to value ratio of 75% or less. This implies a down payment of at least 25% on a property that is purchased, and it means that the homebuyer therefore is borrowing less than 75% of the home's purchase price or appraised value.

A mortgage on a property for which the down payment is less than 25% is called a high ratio mortgage. A high ratio mortgage means that the loan to value ratio is more than 75% but less than 95%. A high ratio mortgage must be insured and this can be accomplished through Canada Mortgage and Housing Corporation (CMHC). CMHC requires all high ratio mortgages to be insured and the maximum insurable mortgage loan is 95% of the property's value. Borrower's may deal with their choice of a variety of lenders approved by CMHC in order to receive the CMHC insured mortgage. Approved lenders include most chartered banks, trust companies, credit unions, and life-insurance companies. CMHC will collect the insurance premium from the borrower and this insurance premium ensures that the lender will be fully repaid in the event of the borrowers default.

Amortization is the length of time over which the loan, principal plus interest, will be fully repaid. Generally, the amortization period can be up to 25 years. Everything else being equal, the longer the amortization of the loan, the lower the required payment. One important financial planning consideration is to shorten the amortization of the mortgage (or any loan) in order to reduce the total interest costs paid to the lender and to build equity in the property as quickly as possible.

Term refers to the length of time for which the lender will, according to the contract, advance the money and for which the interest rate on the mortgage is fixed. Mortgage terms typically vary from six months to ten years. Generally speaking, the longer the term, the higher the interest rate. However, there have been occasions when the short-term interest rates have exceeded the long-term rates.

An open mortgage may be paid in whole or in part at any time and for this privilege, the interest rate is higher than on a closed mortgage. An open mortgage is appropriate when the borrower knows that they will be coming into additional funds, or if they plan to sell the home within a short period of time. An open mortgage would also be considered appropriate if interest rates were expected to fall. Generally speaking, open mortgages are for short duration, typically six months.

In contrast, a closed mortgage has its interest rate set, along with other fixed conditions, for the length of the mortgage term. A closed mortgage usually cannot be repaid in full before maturity without incurring interest penalties. Interest rates on closed mortgages are typically lower than the interest rates charged on comparable open mortgages. The advantage of a closed term mortgage is that the interest rate and payment are locked in for the chosen term. This provides the borrower with cash flow certainty and peace of mind.

A mortgage provides the lender with two types of security. There is:

• the personal covenant of the mortgagor to re-pay and secondly,
• the security of the property that is being mortgaged.

With an owner occupied principal residence there will be no income generated, therefore the creditor is assessing the ability of the borrower to make and maintain all of the contracted financial commitments including the mortgage cost. The lender also assesses the value of the subject property and the character of the borrower as part of their decision-making process.

The assessment of character includes a review of creditworthiness. This is facilitated by a number of means:

1) Credit application.

• A typical credit application will request details in terms of the amount of the loan requested and a statement of the purpose for the loan. The application will also provide details of the applicant e.g. name, age, address, employment, income, assets, liabilities, and ongoing expenses.
• Specifics are also required with respect to the legal description, address, location, and details of the property to be mortgaged.
• Credit applications typically contain a permission clause, which authorize the lender to contact references, verify employment, and to access the applicant's credit history.

2) Credit analysis.

• The purpose of a credit analysis is to determine the borrower's ability and intention to fulfill the financial obligations. This analysis is facilitated by the use of financial data that is provided in the loan application and historical data, which is located in the credit report. Analysis of income, expenses, assets and liabilities is essential.
• Great importance is attached to confirming an applicant's annual gross income, since this value is critical in determining the maximum size of a mortgage or loan that can be prudently advanced by the lending institution.

3) Appraisal of security.

• In order to determine the lending value of the underlying property, a professional appraiser provides an assessment of the property's current fair market value (FMV) for lending purposes.
• The appraisal of real estate uses three approaches: the cost approach, sales comparison approach, and the income approach to establish appraised values.

4) Constraints to lending.

• A major constraint to any real estate lending decision is the loan to value ratio. The loan to value ratio establishes the owners net equity in a property. This ratio is based on the loan amount in proportion to the property's appraised value.
• A second major constraint is the ability of the mortgagor to service the debt. Potential borrowers are often overly optimistic regarding the size of the debt that they can carry. For this reason, lenders will factor into their debt servicing calculations, the additional costs of homeownership as well as purchase costs such as fees charged by CMHC, insurance premiums, appraisal fees, mortgage brokerage fees, land transfer taxes, GST, condominium fees and annual heating costs.

In the event of default on a mortgage agreement, the lender has the following remedies available:

Power of sale

The mortgagee upon default on a mortgage agreement often seeks this remedy, because it is expedient. Since there is no court action involved and there is no statutory waiting period for the mortgagor to refinance, the procedure is quick and inexpensive. This option is most attractive in a stable or rising real estate market where the mortgagee can recover principal and interest. If the property is sold at a price above the amount owing, any remaining funds are paid to the mortgagor. If, after the sale, there is a deficiency, this deficiency is recoverable against the mortgagor.

Foreclosure

Under a mortgage foreclosure, the mortgagee sues for both possession and for payment. A foreclosure can involve a lengthy legal process. Foreclosure is pursued when it is worthwhile to own the property. Alternatively, foreclosure can be viewed as a powerful inducement to a mortgagor to keep current and not to allow payments to fall into arrears or the mortgage to default.

Assumable. This mortgage feature allows a homebuyer to assume an existing mortgage on the purchased home. This can be an attractive selling feature if, for example, the mortgage carries an interest rate that is lower than the current market interest rate. Homebuyers will have to qualify to carry or assume the mortgage debt in order to release the vendor from the responsibility of the mortgage.

Convertible mortgages can be converted at anytime into a longer-term mortgage, without fees or penalties. This feature is attractive if interest rates start to rise.

Portable. Some lenders allow the transfer of an existing mortgage to a new property, subject to certain qualifications. A portable mortgage is appropriate when the borrower has negotiated an attractive interest rate and wishes to maintain that interest rate.

Reverse mortgages can be arranged to provide homeowners with income from the equity they have accumulated in their residence. These plans, also called equity conversions, are sometimes referred to as a homeowner income plan. The process consists of a lender providing funds, secured by a mortgage, which are used to provide income to a homeowner. These income payments may be structured in such a fashion as to minimize or even eliminate income taxes. Upon death, this loan is repaid, often from a sale of the property. This type of financing can have dramatic impacts on the homeowner's estate. Reverse mortgages may work well for homeowners who are asset rich but cash poor, and do not wish to relocate, but nevertheless need to supplement their retirement income.

A second mortgage ranks behind a first mortgage in security. This higher credit risk on the part of the lender is usually reflected to the borrower through the use of a higher interest rate that is charged on the second mortgage.

Split term mortgages are a mix of any two or more mortgage terms in one mortgage product. The advantage of this option is that both an open and a closed term can be held within this one mortgage.

Variable-rate (VRM) The interest rate on this type of mortgage is re-adjusted according to a formula set out in the mortgage contract. Typically, interest on a VRM compounds monthly rather than compounding semiannually, as is the case of a conventional or high ratio mortgage. The interest rates are usually tied to the prime rate or to T-bills. Some VRMs set a cap on the maximum interest rate, or may limit any single adjustment. A VRM is very attractive when interest rates are declining and can in fact reduce the amortization period. Conversely, if interest rates are rising it is possible that payments may not be high enough to cover interest charges and the shortfall is added back to the principal.

Vendor take back is a mortgage provided by the vendor. This type of financing is sometimes set up as a second mortgage with commensurate higher interest rates. The vendor's motivation is typically to increase the appeal or saleability of the property.

2. Loans

Loans can be arranged such that they are either secured or unsecured by collateral. The risk in granting a loan from the lender's perspective determines the interest rate to be charged.

A promissory note is a form of unsecured loan. An unsecured, personal line of credit is a form of a signature loan. Without collateral, the security for unsecured loans is essentially character, integrity, and past credit performance.

A term, or installment loan, which is usually for a specific purpose, has an amortization schedule providing for regular payments. In the case of a fixed installment loan both the term and the interest rate are fixed and do not change over the term of the loan. In contrast, a variable loan carries an interest rate that floats, usually with the prime lending rate. A renewable loan has an interest rate, that is set for a period of time e.g. six months, at which point the loan renews at the current market interest rate. These types of loans are readily available at banks, trust companies, credit unions, and finance companies.

Demand loans are usually secured by collateral such as guaranteed investment certificates (GICs), Canada Savings Bonds (CSBs), term deposits (TDs), mutual funds, or other financial assets. Because the collateral is relatively liquid, demand loans generally carry a lower interest rate than other types of loans. The interest rate charged on a demand loan usually is not fixed and will vary with the prime lending rate. A demand loan can be pre-paid anytime without penalty. As the name suggests the lender, with 24-48 hours notice, can call a demand loan. A margin account at a brokerage firm is a good example of a demand loan.

Overdraft protection is generally short-term protection provided by a financial institution to cover short-term cash shortages. Usually, overdraft protection is attached to a checking account to prevent non-sufficient funds (NSF) charges.

There is a tremendous proliferation of easily available credit in the credit card market. One major contributing factor to the growth of credit is the securitization of asset-backed securities.

Credit cards are a form of revolving credit.

Interest charges and calculations vary from card to card. Some cards charge annual fees, while other credit cards include extras such as air mile travel benefits. There are substantial differences between bankcards and credit cards issued by retail outlets, and these should be researched before obtaining this type of credit.

In recent years, the line of credit has evolved as a very popular and flexible financing option. A line of credit offers several advantages to consumers including:

• A credit limit, when approved, is available to be charged up or paid down at the holders whim.
• A line of credit can serve as an emergency fund.
• Credit can be accessed when the holder wishes to make a purchase or needs to access funds quickly.
• In some circumstances, when a line is paid down to zero there is no cost for keeping the credit line open.

The line of credit is a very flexible product and is suited to consumers who can prudently manage their own credit. There are two types of lines of credit, secured and unsecured. Credit lines can be secured by assets such as a home, stocks, or bonds. With collateral in place such as the above, a secured line of credit will usually bear a lower interest rate, as compared to an unsecured line.

Essentially a lease allows a consumer (lessee) to rent a vehicle or other asset from a vendor (lessor) for a specified period of time at a particular cost. The lease payments cover financing costs, depreciation and other expenses that are incurred over the life of the asset.

Many individuals are strong supporters of leasing due to the perceived flexibility and low initial cash outlay that it provides. If a vehicle is needed for only half of its useful life, a lease can eliminate the time and effort required to dispose of the vehicle after it is no longer needed. Moreover, if technology will rapidly make an item obsolete e.g., a computer, a cancellable lease can protect the consumer.

A lease potentially provides a greater degree of financing since purchases financed by a loan typically require a down payment, or collateral, of 20% or more. Lenders are very reluctant to lend 100% of the cost for any item that is used as collateral. Therefore, the individual with a need but no cash may not be able to obtain the necessary financing. A lease provides an alternative way to consume today, with no equity commitment.

Leases, however, tend to cost more than loans. This is to be expected considering the risk and return issues. Certainly, the leasing company (lessor) bears more risk than a creditor, because the lessor bears all of the normal risks of ownership, such as establishing that insurance is maintained. Further, while the consumer (lessee) has more flexibility to avoid technological obsolescence, the lessor charges a higher rent because they now bear that risk. The same is true with respect to 100% financing. The potential loss due to default is greater to a lessor than to a lender of other types of credit because there is no collateral with which to absorb losses in the event of repossession.

In some circumstances, leasing may be more efficient. Consider the family that needs two cars. If they lease the vehicles, they may pay more for them than if they bought them outright, but they might get a service contract with the lease. The leasing company may be willing to give a discount on service, in order to get the lease.

Who owns the property at the end of the lease? Unless it is specified in the lease contract, the property belongs to the lessor. The lessor stands to gain from any increase in the value of the property. Frequently, this right of ownership upon termination of the lease is given to the lessee for "free". In such leases, the monthly lease payments are higher than they would normally have to be if the lessor retained the ownership of the property.

None of these considerations provides absolute support for leasing. There are some benefits for the lessee, but they tend to raise the risk to the lessor, who therefore charges a higher price. Clearly, by adding a go between instead of buying directly, the additional party must earn a profit and this profit must come from the lease payments.

Leverage refers to using borrowed funds (debt) to finance the purchase and ownership of assets, to magnify the return on investment. Leverage is often measured by the debt/equity ratio. The debt to equity ratio is calculated as total debt (current debt plus long-term debt) divided by net worth.

The use of debt imposes fixed and legally enforceable recurring costs, on a borrower. When an investor borrows (employs leverage) to make an investment, the loan increases the potential variation of yields on the equity portion of the investment. If the investment rises in value and the investor re-pays the loan, the resulting return on equity is enhanced. On the other hand, if the investment were to fall in value and then the investment is sold to repay the loan, the resulting loss on equity is exaggerated. In other words, leverage can be a two edged sword, it can work either for or against the investor.

All lenders are concerned with a debtor's ability to re-pay the loan. The ability to re-pay any loan depends upon a number of factors including existing debt obligations and current uncommitted cash flow.

• Debt burden or debt service measures the percentage of income spent servicing debt. Debt burden equals total debt divided by income.

• Gross debt service ratio (GDSR) calculates the percentage of gross annual income that a borrower spends on basic housing costs. Homeowner mortgage payments, property taxes, annual heating costs, and 50% of condominium fees are divided by gross annual income. As a rule of thumb, GDSR should not exceed the range of 30% to 32% of gross annual income.

• Total debt service ratio (TDSR) calculates the percentage of gross annual income that a borrower spends servicing their total debt. TDSR includes housing costs mentioned above plus all other debt payments. A creditor will normally factor in an allowance for any available, even though unused, pre-existing credit facility. As a rule of thumb, total debt should not exceed 40% of gross annual income.

• Debt to asset ratio or the debt ratio is a measure of creditor protection. The debt ratio is calculated as total debt divided by total assets. The reciprocal of the debt ratio i.e. total assets divided by total debt is called asset coverage.

• Liquidity describes the ability to meet debt service, and other fixed payments in the short term.

• The current ratio measures the ability to meet short-term obligations with short-term assets. The current ratio equals total current assets divided by total current liabilities and is a very important liquidity measure.

• Working capital measures excess liquidity. Working capital equals total current assets minus total current liabilities. Excess liquidity may be viewed negatively because it indicates that there are idle funds that could be more productively allocated to other areas earning higher rates of return on the investment.

• Solvency describes two different measures of financial strength: