CHAPTER 13 Personal Credit, Debt and Lending Introduction In recent decades personal debt has grown significantly in Australia Debt is used for different types of expenditure, and different consumer credit products have been developed to meet these different needs Financial planners need to be familiar with the maths, particularly related to simple and compound interest and mortgage repayments There are traps to be aware of when using consumer credit Interest rates and inflation and tax all impact on saving and borrowing Borrower’s creditworthiness is rated and bankruptcy can result from poor decisions regarding debt The careful use of debt can enhance investment returns Debt Tolerance Most people nowadays have a number of credit products: credit cards, personal loans and/or a home mortgage. While credit and the ability to borrow may be positives that facilitate our modern lifestyle, the ability to borrow can also cause extreme distress when it gets out of hand. It is very easy for people to get into debt over their heads, or at least to use it inappropriately. Growth of Debt • In recent decades the use of debt/credit and the lack of savings has reached worrying levels. • In the 1980s average household debt was 50% of income; in 2008, household debt had grown to 1.6 times income. • ABS statistics indicate that 86% of all household debt is related to the purchase of property. • There is some evidence that the growth in lending has slowed since the GFC. • For most people, the home and superannuation together account for between 75% and 90% of their total wealth Growth of Debt Credit is easily obtained – A typical recent advertisement offered 12 to 24 months interest- free finance, with no or minimal deposit for the purchase of furniture. – Interest applies after the interest -free period. There is no mention of the rate of interest. The store wants the business, the finance provider assumes that enough of the people taking up the offer will be unable or simply will not pay the full price of the furniture by the expiry date, and will finance customers then. Growth of Debt Easy credit carries economic as well as personal risks Before the GFC, the Australian Prudential Regulation Authority (APRA) warned banks against cutting staff and systems and sacrificing risk management for short-term profitability, warning that the growth rate in home lending was unsustainable. It said banks should be preparing for an economic downturn and falling property prices, which will increase the default rates of mortgages. They seem to have been proven to be right, and banks have tightened lending criteria, but many still feel the property correction in Australia is yet to come. Reasons for Borrowing The main purposes of borrowing are to: • fund lifestyle eg holiday • purchase depreciating assets eg a car • acquire a home • invest eg investment property or shares Types of Credit Various credit products have developed to meet these borrowing needs • Fund lifestyle – Credit cards – Re-draw or lines of credit – Reverse mortgage • Purchase depreciating assets – Personal loans – Leasing finance • Acquire a home – Home mortgage loans – Bridging loans • Invest – Margin loans Secured or Unsecured • Secured loans mean that the lender retains title or takes a mortgage against the borrower’s assets (property or other assets) – Principal and Interest Mortgages – Lines of Credit – Balloon Payments Loans – Fixed/Variable Rate Loans – Reverse Mortgages • In unsecured lending, the lender relies on the agreement of the borrower to repay the loan – Credit cards Good Use of Credit Cards • Credit cards are a convenient way of managing our finances • They mean being able to do things and purchase things immediately, without having to carry the necessary cash around with us • It can even be cheaper to use a credit card for purchases if the balance is paid in full each month • Sometimes having a credit card is a necessity Credit Traps • It is said that wise borrowers use low-cost debt to purchase appreciating assets, while foolish borrowers use high-cost debt to purchase depreciating assets or consumer items. • Credit can be used wisely. However, many people find it difficult to resist extending their credit card use to the point of straining the family budget. Credit Traps • A sure sign that credit card debt is out of control is when people withdraw money from one credit card to pay the bill on another credit card! • People who want to have a credit card for convenience or because their lifestyle requires one should shop around for the best interest rate and credit free periods. Questions to Ask to Avoid Credit Traps • What type of ‘deal’ is being offered? Does it suit your personal spending/earning patterns? • Can the minimum payments be comfortably paid? You need to do a monthly cash flow analysis to determine this. • Does the purchase have a clear benefit? Do you really need the item? • Can you wait and save? • Might another type of finance be cheaper? Questions to Ask to Avoid Credit Traps • Will the minimum payment cover the interest accrued and pay off some of the principal? Unfortunately, you will not appreciate this until you have made several payments. But some lenders make the minimum payment low, so that it just covers the interest payments. That means the debt goes down very slowly. Questions to Ask to Avoid Credit Traps • Is the interest rate competitive? Shopping around does take time, but it is worth it. Even though lenders are required to state true interest rates (including fees), the combination of different rates and fees, with different interest- free periods, can be quite confusing. • Is the interest rate higher because reward points are being offered? Where this is the case, really consider the value of the reward points to you. They rarely deliver more than 1% of the value of purchases and few people do the sums. Questions to Ask to Avoid Credit Traps • Initial low interest rate offers for limited periods. Check what the expected interest rate is after the honeymoon period — is it competitive? What shock will it cause your finances once the honeymoon period is over? Can you make the extra payments now and lower the principal? • Always read the fine print and understand the terms and conditions. They may vary between credit card providers. Credit Ratings and Assessments All lenders have credit assessment processes. How thorough the process is usually depends on: • the amount of money being borrowed • what the money is to be used for • who the borrower is • the time period of the loan. Credit Ratings and Assessments Some of the factors that lenders will look at are: • Perceived character of the borrower • Level of income • Job tenure of the borrower • Level of assets available as security or as an indication of wealth accumulation • Credit history or rating from external sources and from the current lender • Amount and term of the requested credit Regulation of Lending Industry The regulation of the banking/lending industry aims to provide consumer protection for both depositors and borrowers. The focus has been on a Consumer Credit Code, which, while state based, has consolidated the previous state Credits Acts. The main features of the Codes are better disclosure before the loan/credit has been advanced and assistance for reasonable cause. Bankruptcy Bankruptcy occurs when an individual’s (family’s or business’s) liabilities exceed their assets and their income can no longer sustain payments of their debts. A bankrupt’s assets are sold and any remaining debts are excused. Nevertheless bankruptcy is not an easy way out of debt. Once a person is declared bankrupt, that information is publicly available. Future requests for borrowing may be denied, even where the bankrupt has repaid the debt. Bankrupts may also have difficulty in obtaining work, rental accommodation and such things as telephone and electricity connections. Alternatives to Bankruptcy • Informal arrangements: This is where the debtor seeks to work with the lender(s) and agrees a schedule of repayments. • Declaration of Intent to Present a Debtor’s Petition, form ISTA — gains a 7-day period to halt action by the creditors to recover debts. Limited relief and can lead to a forced declaration of bankruptcy. Alternatives to Bankruptcy • Part IX debt agreements are only available to individuals who have unsecured debt of under $60,000. This is a voluntary written agreement to clear the debt under a negotiated settlement. • Part X arrangement is where a trustee is appointed and assists the debtor to reach an arrangement with creditors. Deterrents to Savings • Taxation • Interest Rates • Inflation Taxation • The rules of taxation do not favour people who are savers • All interest income is fully assessable for taxation purposes without any deductions or rebates • Potential savers who are high marginal tax ratepayers will see close to one-half of their interest earnings paid in taxes • Sometimes the after-tax interest is barely enough to compensate for the erosion of purchasing power caused by inflation Taxation While there is tax relief for investors in growth assets (discount capital gains tax and franking credits for example), many people may find holding a high proportion of their investments in growth assets too risky Interest Rates • Low interest rates are good for borrowers, but not for people depositing money in a bank or investing in fixed interest investments • Interest rates are the cost of money • Lenders want to be paid for the lack of access to their funds and for any risk that they might not be paid the interest or repaid the borrowed amount • Reduction in interest rates can be particularly detrimental to retirees who are living off their fixed interest payments Inflation • Inflation is the change in the buying power of money over time. • We have all had the experience of going into a shop to buy something and finding that the price had gone up. There was no change in the product; we were just charged more for the same thing. If it is just a temporary price rise, because of a shortage due to a drought for instance, then the price may fall back to its previous price. • However, it often occurs that the price never fully adjusts. Types of Loan Based Savings and Investments • Bank accounts • Cash management trusts • Unsecured or floating debentures • Fixed interest securities Gearing To Invest • Debt can also be used to purchase appreciating investment assets, whether they are property or shares. When money is borrowed for investment purposes it is called gearing or leveraging. • There are three levels of gearing: positive, neutral and negative. Gearing To Invest • Negative gearing occurs when interest payments are higher than be level of income earned from the portfolio, resulting in a cash deficit. The investor’s intention is that capital growth will more than compensate for this loss and will also be more favourably taxed. • Neutral gearing is where the interest payments are at approximately the same level as income earned from the portfolio. • Positive gearing is the least risky position, and as would be expected, provides the lowest potential total return. Advantages of Gearing • Additional capital available for investing • A larger portfolio can be constructed • Allows greater diversification • Tax benefits Issues to Consider Before Borrowing Borrowing to invest is only rational if the money is invested in growth assets. An investor holding fixed interest or cash and borrowing at the same time will always be better off from both risk and return points of view by reducing the cash and fixed interest and repaying the loan. The reason is that rates paid to lenders are invariably lower than rates charged to borrowers because of the charges and margins made by intermediaries such as banks. Borrowing and lending at the same time is therefore rarely a good idea. Issues to Consider Before Borrowing • Additional costs will be generated, including brokerage, lender fees and charges and the requirement to have full personal insurance in place can add to costs. • Investors within a margin-lending package will need to have access to additional security (cash or additional shares) to cover a situation where they do not have enough equity in their gearing package. • Whether home equity or margin-lending, the portfolio will have to be carefully managed to ensure it performs as well as it can. Questions to Ask Before Recommending Gearing Investments • Can the client afford to take up the borrowing, meet the interest payments, reinvest the distributions and still have more than enough money to meet normal living expenses? • Does the client have a sufficiently long investment horizon? Questions to Ask Before Recommending Gearing Investments • Does the client (and their partner) have job stability? • Is the interest rate and the investment markets in a phase that is conducive to gearing? Increasing interest rates and falling markets do not provide a good basis for entering a gearing package. • Does the client have cash or fixed interest investments? If so, these should be transferred to growth assets before gearing is considered. If such a transfer results in an asset allocation outside the client’s risk tolerance, then so will gearing, but with lower expected returns. Questions to Ask Before Recommending Gearing Investments • Does the client have a sufficiently high risk- tolerance to invest in growth assets? • Sensitivity testing indicates that under various scenarios, there is a high probability that the gearing package will provide a positive long-term investment result. • The client has full personal insurance cover. • Where the client has a partner, is that partner comfortable with gearing? Summary • In recent decades personal debt has grown significantly in Australia. • Debt is used for different types of expenditure, and different consumer credit products have been developed to meet these different needs. • Financial planners need to be familiar with the maths, particularly related to simple and compound interest and mortgage repayments. • There are traps to be aware of when using consumer credit. • Interest rates and inflation and tax all impact on saving and borrowing. • Borrower’s creditworthiness is rated and bankruptcy can result from poor decisions regarding debt. • The careful use of debt can enhance investment returns.