Saturday, March 3, 2012

Line of Credit?

For businesses, a line of credit can be a good thing, or indeed, even a necessity.  But much of what works for business is a disaster for the individual - or even a small business.

Opportunity Cost.  Leasing.  Lines of Credit.  In the business world, these concepts often make sense, as businesses, which create wealth and create income, can benefit from these concepts.

I talked about opportunity cost before.  For General Motors, there is an opportunity cost to paying off debt.  While it might improve their balance sheet, they need the money to develop the next generation car, otherwise the business will falter.  Paying down debt has a real opportunity cost for them. However for you, taking on debt and spending more is just spending more - you don't have a new line of products hitting the market.  As a consumer, you just consume, period.

Similarly, leasing might make sense for a big company, as they can expense the cost of a lease and thus not have to depreciate their vehicles.  And for many companies, having a fleet of reliable vehicles is paramount, as you don't want to be dealing with a blown head gasket, when you need to serve customers.  And you don't want to have to hire an army of mechanics to fix old cars and trucks.  And since you get your vehicles at a fleet discount, it is not a bad deal.  For the consumer, on the other hand, it is just a way of spoiling yourself by driving around in a car you can't afford, for a few years.  There are no tax advantages.  And it is the most expensive way to own a car that there is.  You are not saving money, merely squandering it.

But in both cases, that doesn't stop salesmen from applying the logic used for large corporations, to your personal finances.  But you ain't GM - or Apple.  What works for them is financial suicide for you.

And the same is true of lines of credit. For a business, credit can be essential. You buy raw materials, hire workers, and then build a product, which you sell to consumers.  You create wealth, as the sales price of the finished product is more than the sum of the raw materials and the labor.  But to get that first sale, you need a lot of money to build a factory, develop a product, and then hire workers and pay for the raw materials.  And even once you are up and running, you need credit to make this work.  Customers don't pay until they buy the product, so you have a lot of inventory that is "paid for" sitting around for days or weeks, waiting to be sold.

If you paid cash for all that, you'd have a lot of cash tied up in inventory and in salaries and in materials.  And as a result, you'd have to have a lot of cash on hand.  And sometimes, inventories fluctuate, sales are seasonal, and you need credit to carry you over a patch until sales are made.  So many businesses and companies not only sell stocks and also sell bonds - to raise capital - they also set up lines of credit with banks, so they can spot-borrow money.  And often, you hear about companies getting into trouble when these lines of credit are cut off.  But more about that later.

For you, the consumer, a line of credit doesn't make any sense.  Why?  Again, you are not General Motors.  You are not taking iron ore and union labor and making cars in your back yard.  You are merely spending money - that is the consumer's life.  Even if you run a small business, a line of credit can be problematic.

The point is, all the arguments in favor of a line of credit for a company, just don't apply to you, just as leasing and opportunity cost arguments make no sense for consumers.  And when someone tries to tell you they do, they are lying to you and trying to steal your money.  Walk away from such folks.

The lure of the line of credit is the same-old siren song of debt.  You can have it all NOW on E-Z payment terms.  The problem is, like any loan, it has to be paid back, with interest.  And often, years later, you are paying back debt and wondering why you bothered taking it out in the first place.  The thrill of spending lasts for mere nano-seconds.  The pain and drudgery of paying back debt lasts for decades.

You might as well smoke crack - because that is basically the same deal.  A brief high, followed by a lifetime of misery.

Banks offer consumers lines of credit based on their home equity.  Of course, today, this is less so, as up to 1/3 of us have negative equity in our homes.  And in addition, banks are getting wary of letting people "cash out" equity in their home, as it basically was the root cause of the recession of 2009.  Moreover, while such loans may appear to be "secured" by the Real Estate, as a second note, they are second in line to the primary mortgage, and as lenders discovered in 2009, when values drop, there really is no security left anymore.  Plus, clever lawyers can "lien strip" these second notes, leaving the lender holding the bag.

So, perhaps this posting is just of historical note.  Home Equity lines of credit are harder to come by.

When you get such a line of credit, however, they often hand you a little checkbook, which is akin to handing you a little vial of crack.  Suddenly, you have access to a "bank account" of $50,000 or more, with repayment terms amortized over 30 years at a "low" interest rate (usually a few points higher than your primary mortgage rate).  It is tempting to spend, just as it is tempting to go on the pipe.

One month, your bills seem kind of high.  That nagging credit card debt is bothering you - and at 14% to 25% interest rates, certainly not a good bargain.  You think you are clever and decide to pay it all off by writing one of those little crack-checks from your line of credit.  You congratulate yourself for your financial acumen.  After all, you've taken high interest rate debt and converted it to low-interest rate debt, where the interest is tax deductible!

Well, the latter is not really true.  Home mortgage interest is tax deductible up to the purchase price of the home.  If you deduct interest for debt above that initial value (as so many did in the 2000's) it is not allowable.  But since the IRS rarely checks this, many people did it.  Hope you don't get audited.

The second problem with this act of genius is that all you are doing is taking one debt and then tagging it onto your house with a 30-year amortization.  You are not really eliminating the debt, just moving it around.  And the amount of interest, over time, will far exceed the amount you would have paid, if you just got a low-interest-rate credit card and paid it off the regular way.

But time - that is the third problem.  While the amortization may be 30-years, the actual payoff may be far less than that.  Many banks insist that any line-of-credit be paid back in 5, 7, or 10 years.  If you make the minimum payments - based on 30-year amortization, at the end of the fixed period, you may find yourself in a "balloon note" situation, where a large amount is due at once.

The friendly banker will suggest refinancing both your primary note and the line of credit, into a new primary mortgage.  Smart move, except that you are now adding several thousand dollars in closing fees to the balance of your mortgage, even if the monthly payment is less.  You are running as fast as you can, and falling behind, at the same time.  And you just amortized that Big Mac that you paid for with a credit card, over 30 years.  You will be making payments for three decades for meals you pooped out a month ago.

You see, these are not "smart" financial moves.  The basic problem is just plain old spending.  A line of credit encourages you to spend.  And people, being weak, tend to spend until they run out of money - just as a goldfish grows to the size of his bowl.  Just as Boyle's law says a gas expands to fill a container.

"But," you say, "I have the willpower to avoid the temptation to spend!  Tie me to the mast, I can resist the siren song and avoid steering onto the financial rocks!"  Nice try, Hercules, but you get a "No Sale" from me.  No one is that strong, first of all.  Second of all, if you are going to get a line of credit and "not use it" then why get one at all?  There are real closing costs involved, even if you don't use it (in most cases, in others, they may offer "free closing costs" but then jack the rates).

The bottom line is this:  As a human being, you are weak and prone to error.  Rather than deny this and pretend you are a Superman, just admit it and then plan your life accordingly.  Rather than say, "I'm not prone to gambling!  I can go into a casino and not gamble!" you are better off just not going into casinos, period.  Because, if you really don't gamble, then why go?  And if you do have a gambling problem, then why go?  Just don't go - either way.  There is no upside to a casino - or a crack house.

People who get lines of credit will, very quickly - within a year or so - rack them up to the limit.   It just happens, trust me.  You pay off other debts using the line of credit, and then think you are being smart, so you rack up more debt.  Or you decide to buy a new car, using your line of credit, and think you are being "smart" for "paying cash" (which you are not) and using deducible debt (which it is not).  Everyone does it (or did it).   Period.  No one goes to the strip club and doesn't order a lap dance.  Never think you are immune from being human.

And yes, we had one of these home-equity lines of credit.  Heck, back then everyone did, and at the cocktail parties on the street, 30- and 40-something homeowners would hold forth on what a great deal it was, and we'd all nod in agreement about what financial superstars we all were, for taking advantage of these "smart deals" as "smart consumers".  Hey, did I mention all the flyer miles I'm getting on my credit card?  Oh, really?  Do tell!  Can I get you another drink?

Oh, those were the days.  Were we ever that young and naive?  Oh yea, we were, as a nation.

Borrowing more and more money is never a good plan in life.  Limit borrowing to situations where you really, really need to.  And even then, minimize the borrowing.  The problem with debt is that since the "monthly payments" initially appear low, it is tempting to spend more - to buy brand new, instead of used, to buy the GT model, instead of base SE, to go to a more expensive school, rather than a State one, to buy a deluxe house with sun nook, instead of a house you actually need.  Loan money is funny money, and like lottery winnings, is easy to spend.  Unlike lottery winnings, you have to pay it back - with interest.

What about small businesses?  It is tempting as a small businessman to get a line of credit.   Customers may be slow to pay, and you may need money to make your tax payments and other bills which come due and are not extendable.  However, taking on more debt may not be such a smart move for a small business, as it masks the underlying problems of the business.

For example, when I ran my firm, I had a line-of-credit with American Express.  I used this when I needed to make payroll and pay withholding, which are not bills you can extend.  And for a while, it seemed to be working out OK.  But what I was failing to realize was that (1) I was not bringing enough money into the joint, and (2) I had way too much overhead for the amount of business I was doing.

I hired more people, but they did not produce enough billings to justify their salaries.  And stupidly, I hired more support staff to do work for me, but didn't have time to supervise them properly.  And I over-paid them.  I made money, as a one-man shop (and should have left it at that) but lost money as a four-man firm.

The line of credit masked this effect for a year or more.  But one day, Amex decided to cancel my line of credit.  They based this on my credit report, and it was all done by computers.  Their computer pulled my credit report (I think scores did not exist then) and then made an automated decision to keep or cancel the line of credit.  It then generated a letter which was mailed out to the consumer.

Problem was, between the time the letter was generated and the time I received it, I used the line of credit to make a deposit to my bank account to cover payroll and taxes.  And when that line-of-credit check bounced, well, it started a cascade of problems.  Fortunately, my bank was able to extend me a line of credit, and that turned out to be a better deal, in that at least it was not cancel-able at will and they would at least call me if there was a problem.

But lesson learned, and I realized that running this debt hamster-wheel was a false value and a bad idea.  I laid off the staff and went solo again, and found myself having a lot more fun, and actually making more money.

And when I read the financial pages, I saw that many large companies had the same experience I did - they would get into a small financial difficulty, and their lines of credit would not be renewed, and as a result, their small difficulties snowballed into huge ones - and this often meant bankruptcy.

A line of credit leverages you, financially.  It hollows you out.  And when you do this, you make yourself more vulnerable to the whims of financial weather.  You have a dry spell, for example, and it wipes you out.

And that is, by the way, what bankrupts farmers - debt, not drought.  A drought may cause a farmer to lose a crop or lose money.  But it is failing to service huge debts that makes him insolvent, bankrupt, and eventually, no longer a farmer. The farmer with less debt, or no debt, has a better chance of surviving the drought - and then buying his neighbor's farm at the bankruptcy auction for pennies on the dollar.  Kind of harsh, but that's business.

I have been very lucky, in life, and part of this luck was, in some instances, being able to see the writing on the wall and get out while the getting was good.  In my small law practice, I saw the debt load increasing and I got out.  I listened to the nagging little voice in the back of my head saying "debt ain't right" instead of the siren song of commerce that shouted, "More debt is better!  See if you QUALIFY!"  A friend of mine was less lucky - he went millions of dollars into debt, hiring 14 attorneys and finally had to sell out his practice to another firm.

In the home arena, the same thing happened.  That little voice in the back of my head said, "Gee, we are taking on more and more debt, and not paying down our mortgage, but increasing it, over time."  Others listened to a different song - which was on the top-40 at the time - which sang, in sweet, soothing tones, "You'll never pay off your mortgage anyway, don't sweat it!  Debt is good!  Cash out the equity in your home and enjoy life!  It's what the smart set is doing!"

So I sold out of Real Estate, before the market crashed.  Smart?  Perhaps.  Lucky?  You bet.

But a lesson is learned - taking on more and more debt is never a good move.  And "lines of credit" are as dangerous as lines of cocaine on a broken mirror.  They are tempting and evil, and in exchange for short-term pleasure or relief, they provide long-term misery and deprivation.

If you are thinking about a home equity line of credit, think again.  Think why you need to take on more debt, and whether this is truly a smart idea.  Chances are, it isn't.  Chances are, you don't need it.  Chances are, it is a really, really bad idea you should run, not walk away from.