Tuesday, October 16, 2007

Can debt be a safety net?

Normally, I dismiss the countless unsolicited financial products I get in the mail every month out of hand, but I'm tempted to bite on a particularly persistent one. In the deluge of pitches I receive from my bank, Royal Bank, every month, one of the recurring items is an offer of an unsecured line of credit. They're offering $10,000 at a rate close to prime, if I recall correctly.

I currently have a high-interest savings account that doubles as an emergency fund and condo downpayment fund. If something like a job loss were to happen now, that's what I'd be dipping into to tide me over. But when I eventually come around to buying a place of my own, I'll probably be inclined to empty the entire thing (so as to maximize my downpayment) and knowing myself, I know I'll be tempted to pour every spare cent I have into paying off the mortgage after that -- at least for the first year or so, until I've convinced myself I'm not actually about to get fired on a daily basis.

The long and the short of it is, when I liquidate the fund to buy real estate, I'll find myself in the position of not having an emergency fund, at least in the short term, to pay for those unexpected emergencies. (I'm told having three months' expenses is a good guideline.)

What I'm thinking of doing at the moment is to sign up for this unsecured line of credit as a sort of insurance policy. It doesn't cost anything on a monthly basis unless I take money out of it (which I wouldn't do as long as I had that $10K in savings I currently have) at which point I'd pay interest on the withdrawals. That way, should the need ever arise, I'd dip into the line of credit, as opposed to the emergency cash that's I'd already have wisely invested into minimizing my mortgage.

I suppose this is all moot until I actually need it, but I'm tempted to sign up for it now. I'm sure the rates offered by banks on unsecured loans start to change once you've borrowed six figures to buy a house, so my reasoning was to sign up now while I'm an excellent credit candidate.

Any thoughts on this? You don't have to remind me of all people that, as a general rule, debt = bad, but is it not better for my long-term financial wellness to not have 5K or more sitting around in a savings account when that money could be put toward paying down a future mortgage? I suppose there might be some negatives in terms of credit rating to consider, but the thought of having several grand sitting in a bank account while I have a six-figure debt to pay off doesn't sit right with me -- and I haven't even taken the plunge yet. It just seems a waste to hoard cash for a rainy day that might never come.

Is this not a situation where debt is actually the smart financial decision?


FourPillars said...

You should absolutely get the LOC.

It doesn't cost anything and it's there IF you need it. Just because you sign up for it and use it as an emergency fund doesn't mean you have "debt".


nancy (aka money coach) said...

This is a text-book case study -- the mix of money and the 'human factor'. For you, I suspect it's smart. But for others, it's a potential liability. There is ALWAYS stuff coming up in life that seems utterly imperative at the moment, that could lure anyone into diving into the LOC. Et voila, join the ranks of the over-our-heads-in-debt. But if you know yourself enough to be confident that you would only use it in pre-defined emergencies, it's a smart safety net.

philip b said...

Keep in mind that any line of credit will increase your TDSR (Total Debt Service Ratio) even if you have nothing owing on it. This means the bank will not lend you as much money as they will hold a "payment" on this line of credit against you when determining debts vs. income.

Krupo said...

philip b's comment says it all - it'll be just like any credit card limits you have - it's treated as open debt whether you're using $500 or $15,000 of actual credit/LOC.

This could impact the amount you can borrow, and the rate you're charged on your other loans.

If $10k is too much, consider a smaller LOC too...

Mr. Cheap said...

I was going to write exactly what philip and krupo beat me to. It won't hurt your credit rating (much, the pull is a tiny, tiny hurt, but is really nothing, and quickly it should start IMPROVING your credit rating as you'll establish more of a history).

If the $10K really affects you TDSR to the point that it prevents you from buying something, that buy would probably have been a real stretch anyway (so maybe its a good thing). From what I've read about you I suspect you'll easily get approved for as much as you want on you mortgage.

The other way around this would be to get a pre-approval, THEN set up the unsecured LOC. Or get a mortgage with a build in secured LOC, then as you pay down you mortgage, you create room in the HELOC to borrow against in case of emergency.

I'm a big believer in using LOCs/HELOCs for emergencies instead of having cash sitting there.