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February 1, 2018 | Not Good

A best-selling Canadian author of 14 books on economic trends, real estate, the financial crisis, personal finance strategies, taxation and politics. Nationally-known speaker and lecturer on macroeconomics, the housing market and investment techniques. He is a licensed Investment Advisor with a fee-based, no-commission Toronto-based practice serving clients across Canada.

This got Dan’s attention.

“My wife works at one of the big five banks,” he says. “Front lines. She has, by the clients’ requests, transferred mortgages to HELOCs, so they can pay interest-only. I can’t find any data or charts on this, but it definitely has the potential to become a worrying trend. Scary. This tells me one thing. It can be done.”

You bet. It’s one of the current hot tricks for dealing with debt you can’t service, especially since the great real estate escalation is kaput. Buying more house than you could ever afford (because ‘prices always go up’) is so 2016. This year, with markets flatlining, B20 landed and mortgage rates rising, debt’s toxic. Especially amortized debt, which forces principal repayment.

Background: HELOCs, or home equity lines of credit, are loans made by bankers and secured (on title) by your real estate. In effect, you’re reaching into the property’s equity and pulling it out to spend. Being secured, the rate is low – usually prime plus a half point (bank prime is now 3.45%, so HELOCs sit at 3.95% or higher).

These lines are normally set up as demand loans, meaning repayment can be demanded at any time, plus they have variable rates – rising each time the Bank of Canada rate increases, as it did last month. But borrowers need only make simple interest payments. No amortization. So they can (a) just pay the interest on the outstanding balance for that month, or (b) make no payment and let the debt grow to reflect the accumulated interest.

By the way, you can borrow up to 65% of the equity in your home through a HELOC, or  expand that to 80%, with the remaining hunk treated as a conventional mortgage. Most people, of course, go for the interest-only basic amount.

Here’s the math. A $400,000 conventional mortgage amortized over 25 years with a five-year rate of 3.4%, has a monthly of $1,900. If it’s converted to a $400,000 HELOC, even at the higher rate of 3.95%, interest-only payments equal $1,300. You have the same debt. You dwell in the same house. You deal with the same lender. But you pay 30% less.

For people living on the edge, it’s a huge saving. Of course, they have zero protection from rising rates and the lender can cream them at will. But, it’s cheaper. If you have no other options, it’s an easy one – even as risk is elevated dramatically.

Here’s the very scary part.

 In 2016 outstanding HELOC balances reached $211 billion and are estimated to be $220 billion at the moment, owed by more than 3,000,000 families. According to the Financial Consumer Agency of Canada (a federal government body), “many are making the minimum payment (i.e., interest-only payments) or making only occasional efforts to reduce the principal.

“Research indicates that roughly 4 in 10 consumers do not make a regular payment against their outstanding HELOC principal, and 1 in 4 only cover the interest or make the minimum payment. HELOC borrowers can find themselves in a “home equity extraction debt spiral,” particularly during periods of financial distress. When consumers borrow against their home equity to make ends meet, they run the risk of having to extract more equity down the road just to cover the minimum payments on their HELOC. This pattern of behaviour may lead consumers to add to their debt burden during periods of financial distress rather than reigning in discretionary spending.”

These numbers are incredible. But apparently true. They’ve been confirmed by the Chartered Professional Accountants of Canada, which discovered that 41% of all HELOC borrowers are making no regular payments that cover interest or principal, while 27% make pay the minimum monthly interest.

Okay, so we have some evidence that not only is HELOC borrowing huge and growing huger, but that banks are letting clients turn amortized mortgages into simple-interest demand lines of credit – just as the real estate market starts into an inevitable corrective phase. We also know interest-only mortgages played a key role in helping to blow up the American real estate market, sending the world into the 2008-9 credit crisis. US homeowners took OIMs for houses they could not really afford on the expectation rising property values would let them eventually convert to traditional loans. But when the wheels fell off, home equity was wiped out, the refinancing option evaporated, and owners began to default.

In Canada, walking away from a mortgage is a no-go in most provinces. Thus, a likely outcome of rising rates and falling prices is a wave of listings as the HELOCers bail. Meanwhile, every month that 40% of them fail to make payments, their indebtedness grows. The federal government pointed out a year ago if interest rates were to rise 1%, one million families would be in trouble. Since then, rates have increased three-quarters of that amount.


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February 1st, 2018

Posted In: The Greater Fool

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