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The Power of Flexible Terms

While portfolio lines of credit do offer some of the lowest rates in consumer lending – the key when positioning with clients is that lending is not all about rate.  In fact, the terms of a loan are frequently far more important than the rate.

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“What’s the rate on the line of credit?”

This is the classic question you are likely to receive from your clients when proactively setting up lines of credit – and it’s an important one.

First of all, the answer is always that “it depends”.  The fact is that the rate is floating – it changes.  The only time the rate matters is when there is an actual draw, and then it becomes very important.

Portfolio lines of credit do offer some of the lowest rates in consumer lending. But the key when positioning with clients is that lending is not all about rate.  In fact, the terms of a loan are frequently far more important than the rate.

Consider this scenario, in which an advisor and client discover the power of flexible loan terms.

Mr. and Mrs. Saver were well on track for retirement.  They had $1,000,000 in a 401(k), and their lifestyle would be completely funded by their pension and Social Security upon retirement. All they needed to do was get to full retirement age and everything would be taken care of. They also had $150,000 in after-tax assets saved, but this was their rainy day fund, and they were reluctant to ever touch this money.

Then Mr. Saver was forced into early retirement and everything changed. They had about a $1,000/month gap between their income and spending until they would tap Social Security at full retirement age. They needed to liquidate about $24,000 from their portfolio to finance their lifestyle until activating Social Security.

Additionally, they had another $1,000/month in car loan payments. They took a car loan out through the dealership and were on track to pay it off on the day Mr. Saver had originally planned to retire.

They didn’t want to touch their $150,000 after-tax rainy day fund, but they did have access to a line of credit against this account at around 4%.  Given that the car loan was offered at 3% and they had enough income to cover the payments, the car loan was the right choice at the time.

Even though the line of credit had a slightly higher rate, it did not have a mandatory monthly payment associated with it. This proved to be a major downside of the car loan when Mr. and Mrs. Saver’s situation changed.  Exploring the possibility of refinancing the car loan to their line of credit yielded the following results:

It turns out that refinancing to a slightly higher rate loan (with more flexible terms) would actually put an additional $2,370 in the Savers pocket, versus paying the car loan down with their 401k.

The Power of Flexible Terms

Auto Loan Refinancing Table

Current Auto Loan Refinancing to a line of credit
Balance $24,000 $24,000
Rate 3% 4%
Total Interest Over 24 Months $690 $1,920
Total Taxes from 401(k) Withdrawal $3,600
Total Cost $4,290 $1,920
Savings from Line of Credit $2,370

It turns out that refinancing to a slightly higher rate loan (with more flexible terms) would actually put an additional $2,370 in the Savers pocket, versus paying the car loan down with their 401k.

Further, this doesn’t factor in the growth the $24,000 could have had over that period by being invested – an important opportunity cost.  Had the portfolio averaged a 6% rate of return, this would increase the value of refinancing to the line of credit to about $5,000.

Put another way, the rate on the line of credit would have had to be over 9% in order for selling from the 401k to pay down the loan to make financial sense.

The important lesson to learn here is that lending is not all about rate.  The terms are just as important – often more important.

This is what a Personal CFO does for their clients – they look at their clients’ financial lives through a holistic lens, looking at all the tools in their toolbox to do what’s best for the client in the given environment.

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