Running out of money is a financial worst-case scenario – but it happens.
It doesn’t take a catastrophe to experience a temporary cash crunch. Moving or switching jobs can sometimes cause serious, if short-term, liquidity issues, with financial outflows sometimes hitting your wallet before it is replenished by new money coming in. And sometimes even the recommended rainy-day fund of three to six months worth of living expenses isn’t enough to cover a sudden, emergency expense.
So what are the best and worst ways to get money quickly when you need it? Global News put that question to David Gowling, senior vice president at debt consultancy MNP in Burlington, Ont., and Scott Hannah, head of the B.C.-based Credit Counselling Society. Here’s an amalgam of how they ranked the available options:
A line of credit works a bit like a credit card. It allows you to borrow money up to a pre-set limit, but you don’t have to use the loan until you need to and then you only have to repay the amount you borrowed. Unsecured means your financial institution is lending you the money without using assets, such as your home or car, as collateral. For many Canadians, unsecured lines of credit come with a reasonably low interest rate (think 5-7 per cent), zero fees and fast set-up, which is why both Gowling and Hannah put it at the top of their ranking. You can often borrow as little as $5,000 and up to several tens of thousands of dollars with an unsecured line of credit, which makes it a good option for emergency home repairs like fixing a leaky roof.
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One of the downsides, however, is that minimum payments on lines of credit are often interest-only, which means your debt will become permanent if you only have the budget to repay the minimum, Gowling warned. Another potential drawback is that relying on lines of credit is so easy that it can quickly become addictive, he added. Over-reliance on lines of credit can be a slippery slope into unmanageable debt problems, which is why many debt consultants advise against relying on lines of credit as a substitute for having an emergency fund.
Also, “those with limited income or a less-than-perfect credit score may have trouble accessing this type of loan,” Gowling said.
Finally, keep in mind that lines of credit come with variable interest rates that may go up over time.
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A Tax-Free Savings Account (TFSA) is where a lot of people store their emergency fund because any money sitting there grows tax-free and can be withdrawn at any time with no cost. If you have a plump rainy-day fund in a TFSA and your furnace goes bust or you lose your job, we don’t need to tell you what to do. And any money you take out frees up contribution room, which you can start filling the following year.
The case for tapping your TFSA, however, becomes less clear-cut if you’re using the account to save for retirement. For Canadians with limited income and in a number of other cases, TFSAs can be a better way to save for retirement than a Registered Retirement Savings Plan (RRSP). If the TFSA is the home of your nest egg, it may make sense to tap a line of credit instead. If your money is invested, your annual rate of return may be higher than the interest rate you’d be paying on a loan and you may not be able to turn those investments into cash without incurring steep costs, Gowling noted.
However, if you decide to opt for taking on debt instead of depleting your savings, make sure you have a realistic plan to repay what you owe.
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Home Equity Lines of Credit, or HELOCs, are lines of credit backed by the equity in your house. Because the bank can count on your property as collateral, the interest on HELOCs is usually considerably lower than that for unsecured lines of credit, though a bit higher than mortgage rates. HELOCs also allow you to borrow large amounts of money. If you have, say, $100,000 of equity in your home, you might be able to get a HELOC with a credit limit of close to that amount. That, and the low borrowing costs, make HELOCs a fan favourite among Canadians looking to finance home renovation projects. But HELOCs can be used for anything, not just home-related expenses.
If you own a home and already have a HELOC already in place, that should probably be your go-to option. But HELOCs pose some of the same risks that unsecured lines of credit do: They have variable interest rates and they easily turn into a debt trap if you make a habit of tapping them to cover expenses for which you didn’t budget. HELOCs have a particularly bad track-record when it comes to debt consolidation. Homeowners who consolidate, say, expensive credit card debt into one low-interest HELOC often wind up using their line of credit just like they used their credit card, according to the Credit Counselling Society.
Also, if you don’t already have a HELOC, “there will likely be closing costs to obtain a [one] as it is registered against the title of your home,” Hannah said via email. In addition, the application process can be slow, and Canadians will now have to undergo a financial stress test introduced by federal mortgage rules implemented over the last couple years, Gowling noted. “This may limit the amount of equity that can be utilized,” he said.
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For smaller emergency expenses, such a pricey car repair, you could ask for a higher the limit on your credit card or apply for a new one. If you have a good credit score, either process will be relatively quick, Gowling said. The advantage of credit cards is that if you manage to repay your balance in full by the due date, you won’t pay any interest, which means you get to borrow money for free. The catch, of course, is that interest rates, when they do kick in, are very high – typically around 20 per cent and often higher. And if your credit card balance swells to a point where you can only afford minimum payments, it will become very difficult to pay off that debt.
Unlike lines of credit, term loans have a set repayment term and interest rate. “The interest rate may be similar to an unsecured line of credit and is a good option if you have a good credit rating and need a larger amount of money and longer repayment term,” Hannah said.
This is the cash banks will temporarily put up for you if your chequing account is overdrawn and you have so-called overdraft protection. The amount generally ranges from a few hundred to a few thousand dollars.
“This is a good option if this is a short-term problem for a relatively small amount of money and you are able to repay the amount borrowed within a couple of months,” Hannah said.
Still, this option usually comes with steep fees and double-digit interest rates.
You can also get a cash advance using your credit card, either at an ATM or at your financial institution. You’ll be borrowing against your credit limit, but the costs will be steeper. For one, there is no interest-free grace period: Interest will accrue from the date you get the cash advance until you’ve paid it back. Also, the interest rate on cash advances is usually higher than that for regular purchases.
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Got a boat or trailer you rarely use? Consider offloading those assets to get the cash you need, Hannah said. Having to sell property might be psychologically unpleasant, but it’s preferable to getting into a debt you’ll struggle to repay or putting a significant or permanent dent in your retirement savings.
This entails repackaging your mortgage in order to pile a new loan on top of whatever you already owe on your home. The advantage of doing so is that the new, larger mortgage will come with pretty low interest, Hannah said. The problem, though, is that this has “long term implications, as you are now amortizing the amount you borrowed over a long period of time (20+ years) and there will likely be legal costs to arrange this.” You may also incur penalties for breaking your original mortgage, Gowling noted.
Besides, you might not be able to qualify for refinancing under the new, stricter federal mortgage rules, Gowling added.
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A second mortgage is a loan backed by a home on which you already have a mortgage. You’ll be paying a higher interest rate on this loan than you do on your mortgage because your lender doesn’t have first dibs on the property. If you default on your payments and lose your home, it’s the lender on your first mortgage that will be paid first.
Still, interest rates on a second mortgage are generally lower than those that come with unsecured loans, Gowling said. Another plus compared to lines of credit is that “monthly payments will include both principal and interest so there is an end date to the payments.”
And adding a new mortgage instead of refinancing the one you have might make sense “if the debt is amortized over a shorter timeline. You could end up paying less interest,” Hannah said.
Still, carrying two mortgage payments can be tricky, Gowling warned. Getting a second mortgage in order to consolidate other debt is a financial red flag, he added.
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Where to place an RRSP withdrawal in this ranking seems a bit of a philosophical question. Gowling placed it fairly high up, noting that it’s another way to get cash without incurring potentially expensive debt. Hannah, on the other hand, placed it just at the bottom of his ranking, just above payday lenders. The drawbacks of pillaging your RRSP are many, he said. You’re taking away from your retirement funds and, unlike a TFSA, you won’t have the ability to repay the funds you withdraw at a later date. And that RRSP money may cost you a lot in taxes.
For example, say you withdraw $15,000 from your RRSP. What you’d actually receive is $12,000. The bank would remit $3,000, or 20 per cent, to the government as a so-called withholding tax.
Second, the full amount of your withdrawal – $15,000, not $12,000 – would count as taxable income on your tax return. This would be added to any other money you’ve made that year, potentially bumping you into a higher tax bracket.
This may surprise some, but both Gowling and Hannah ranked borrowing from family and friends as one of the most undesirable options for getting through a money squeeze. The advantage, of course, is that family loans often come with a flexible repayment schedule and little, if any, interest.
“I would caution against approaching family and friends for assistance as many relationships have been permanently damaged as a result of borrowing money,” Hannah said.
Generally, family loans can be a good option for a one-time emergency, and if you’re confident you can repay the money in a reasonable amount of time, Gowling said.
Alternative lenders serve borrowers with poor credit records, but the interest rates can be as high as 30 per cent. You can get both unsecured loans or use assets such as your car or home as collateral, which might lower your borrowing costs somewhat. You might be able to borrow up to several tens of thousands of dollars.
Alternative loans “can be a short-term fix for those with a poor credit rating but who do have the ability to repay the loan quickly,” Gowling said.
Payday loans are the last resort. These are short-term loans with extremely high fees and interest that can quickly rise beyond your control if you don’t quickly repay your debt. And you can’t borrow much with a payday loan, anyways. According to the Financial Consumer Agency of Canada, the current credit limit is $1,500.
As you can tell from the name, the idea of a payday loan is that you’ll repay what you owe when you get your next paycheque. The loans are meant to cover a small cash shortfall until the next pay cycle, and generally the lender will help itself to the contents of your bank account when the loan is due.
The annual interest rate on a payday loan can easily amount to several times the principal, so even if you repay your debt quickly, this is a very expensive way to borrow. For example, borrowing $300 for two weeks might cost you $63 in interest with a payday loan, compared to less than $7 with a cash advance on a credit card or overdraft protection on a bank account, and less than $6 with a line of credit, according to the FCAC.
If you miss the payment, you’ll owe $363 plus, say, a $40 penalty, for a total of $403. Things could get out of control fast.
That said, provincial regulations of payday loans, with some imposing strict restrictions on what’s allowed.
Still, “if a payday loan is the only option, that’s an indication of serious financial problems,” Gowling said.
© 2018 Global News, a division of Corus Entertainment Inc.