Banks - Millionaire on the Prairie

Right of Offset

Over the past few weeks, I’ve heard people talking about the right of offset. As I understand it, the bank who lends you money has the right to take money out of your bank account, held at the same bank, if you don’t pay your debts on time.

Wait! What? Start from the beginning, Blue Lobster…

Allow me to paint you a picture. Let’s say that you have an outstanding loan at Bank A for $7,500. And you also have a bank account at the same bank with a balance of $3,500. We can call this $3,500 your emergency fund. Or it can be your hope-to-one-day-get-on-a-plane-again fund. Call it whatever you want. The point is, this $3,500 is money in an account held at Bank A.

Right now, we’re living in COVID-19 times. You have to prioritize your money since your income has been cut or eliminated. Maybe you’re one of the lucky ones who still has a steady paycheque coming in on a regular basis, but you’ve heard rumours of layoffs at your place of employment. You wisely choose to spend your money on shelter, food, and utilities. And maybe you’ve decided to cut certain expenses from your budget in an effort to save money. You may even have chosen to not pay your loan right now.***

*** To be extremely clear, I am not advocating this course of action. I think this option causes more problems than it solves, but you know your circumstances far better than I do. Go forth and handle your money however you think is best in your situation. ***

Let’s say Bank A notices that you’ve stopped making payments on your loan. They also see that you have money in an account at their fine institution. Bank A chooses to offset your debt with the money in your bank account. Again, the bank to which you owe money has the right to take money out of your account to pay your debt. It’s the right of offset, and its application stings!

Blue Lobster, is there anything I can do to stop my bank from taking my money?

Of course there is. The first method to prevent the bank from exercising the right of offset is to make your loan payments on time. Prevent your bank from ever wondering about your capacity to repay your debt. Banks like to get payments so pay them.

The second method is to move your bank accounts to a bank where you don’t have any loans. For example, you can move your $3500 to Bank H. Your money will be there when you need it. Of course, you will still owe the debt to Bank A and you should do everything in your power to pay off that loan.

Again, I’m going to be annoyingly explicit about this point. Moving your money to Bank H doesn’t eradicate your debt obligation. You still owe $7,500 to Bank A. Moving your money simply eliminates the risk of Bank A taking money out of your account to satisfy your debt if you stop paying your loan.

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Weekly Tip: Do what you have to do so that you don’t pay bank fees. For the vast majority of people, this means opening an account at an online bank. There are free bank account out there. If you’re still paying bank fees, it’s because you’re choosing to do so. Make a different choice and keep those fees in your own pocket. Use them to buy stock in the bank instead.

Beware the Minimum Payment!

Right from the get-go, I’m going to ask those of you who already know this to forgive me for stating the obvious. Minimum payments benefit the lender way, way, way more than they benefit the borrower.

Beware the minimum payment!

When you borrow money from the lender, you’re taking out a loan. And when you do so, you’re agreeing to pay interest on the money borrowed. The loan is governed by a contract, so the very best time to amend the terms of the contract – and thereby the terms of the loan – is before you sign the contract!!! In other words, don’t take a loan if you don’t believe that the terms of the loan will be beneficial to you.

The repayment terms of the loan are set out in the contract. If you don’t like them, or the lender won’t change them, then don’t take the loan. This is the most effective way for you to avoid having repayment terms in your life that may cause you financial grief in the future.

And for those wondering how to buy what you want without a loan, the answer is that you will require a combination of cash and patience. Save up your money then make the purchase. You’ll get what you want. You won’t pay any interest. It’s the ideal situation so strive to make it your reality.

However, there are times when you simply need to borrow money to get what it is that you want. If this is the situation in which you find yourself, then I want you to be very aware of the trap of minimum payments.

Making minimum payments benefits the lender because they can charge you interest on the outstanding loan balance for the longest period of time. If you take out a 5-year car payment, then the loan is structured so that the lender earns as much interest as possible off the loan. In other words, you as the borrower will pay back the maximum amount of interest.

The legal way to minimize the amount of interest you re-pay on the loan is to make extra payments. Get a second job – sell some stuff online – cut some subscriptions from your life. However you choose to find extra money is up to you. The bottom line is that you take that extra money and apply it to your outstanding loan. Go back to the car loan for a hot minute. If you can make extra payments on the loan and pay it off in 2 years instead of 5, then you will keep three years of interest payments in your pocket rather than sling that money into your lender’s pocket.

As of the date of publishing this blog post, the banks in Canada are allowing mortgage holders to apply for a six-month deferral of their mortgage payments. If approved, people who have mortgages won’t have to make mortgage payments for six months. It’s called a mortgage deferral.

This deferral means that the people who took out a mortgage will have to repay the money, eventually. (I’m not an expert on how the program works. If you need the details, please contact your bank.)

Make no mistake. The banks want their money back. The banks lent the money to borrowers at an agreed-upon rate of interest for an agreed-upon period of time. That the banks are allowing borrowers to defer repayments on their mortgages is quite unprecedented in my experience. What I wonder is whether the borrowers understand that a deferral of their mortgage payment is not the same as a waiver. The deferred payments are still outstanding. And borrowers will continue to owe interest on those payments until the money is repaid to the lender.

Again, the banks want their money back. So if a borrower receives a deferral from their bank, the borrower still has to repay that money. And guess what? Interest will continue to accrue on that deferred payment.

What? Are you surprised? Did you think that the banks would stop the interest clock from running? If so, gently hit yourself on the head with a hammer. Of course, the banks are going to continue to charge interest on their loans.

This is not a debate about the morality of the banks during the COVID19 pandemic. What I want to impart in this post is that the second best option is to get out of debt as fast as possible. Minimum payments are not your friends. In the case of a mortgage, the numbers are a lot bigger so a deferral is going to mean a much higher amount of interest will be charged during the deferral period.

If you’re considering applying for a mortgage deferral, keep the following in mind. A deferral means that the money is not being paid back as agreed upon in the loan. It does not mean that the money remains outstanding without interest being charged by the lender.

Allow me to state this concept another way. The interest only stops accruing when the loan is repaid. Paying later means paying more interest. The only way to avoid the interest charge is to repay the loan.

Beware the minimum payment! It never benefits the borrower.

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Weekly Tip: Once you’ve finished making debt payments to a lender, continue making those same payments to yourself. Re-direct your former debt payments to a high interest savings account. You were living without the money when you had a debt, so continue to live without that money when the debt is gone.

What is a HELOC?

What is a Home Equity Line Of Credit? Short answer – it’s a debt trap that’s best avoided.

At its heart, a HELOC is a debt product that banks offer to homeowners which permits the homeowner to go into debt by spending the equity in their home without selling it first.

For example, if you have $200,000 worth of equity in your home, you can get a HELOC for an amount up to $200,000 depending on the lender. Without a HELOC, you would have to sell your home to get your hands on the equity. In other words, someone would give you money in exchange for your house and you could then spend that money however you wanted. There would be no fees or interest payable on that money because it would be yours.

The HELOC is a completely different beast. With a HELOC, you get access to the equity in your home via a loan from the bank without first having to sell your home. This sounds like a good thing, but it’s a debt-trap that you would be wise to avoid.

Banks charge interest on outstanding HELOC balances

You must keep in mind that the banks will charge you interest if you use a HELOC. Again, you’re spending your equity via a loan from the bank. Any bank loan is accompanied by an interest payment. Interest accrues until such time as the HELOC balance is repaid in full and it runs from the moment that you use it.

The interest rate on a HELOC is usually lower than the interest rate charged on a regular Line Of Credit. A regular LOC is an unsecured product, whereas your home secures the HELOC. If you don’t pay back your LOC, the bank cannot initiate foreclosure proceedings and take your home away from you. This is why they charge you a higher interest rate on a LOC.

Banks can foreclose on you if you don’t repay your HELOC

Before extending you a HELOC, the bank puts a charge on the title to your home. This charge against your title is similar to a mortgage. It ensures that if you ever sell your home, the bank’s HELOC will be repaid from the proceeds of the sale. You’ll get whatever’s leftover after the mortgage debt and the HELOC debt have been repaid.

Again, this particular debt product is essentially a loan against your home. It allows you to spend the equity in your home however you want. No one will be watching you to ensure that you don’t spend your equity on items which will not increase your financial security.

Having a charge on your title makes you vulnerable. Should you fail to make your monthly payment on the outstanding HELOC balance, the bank has the right to foreclose on your home to get its money back. Also, the bank has the right to demand full repayment on an outstanding HELOC balance whenever it wants. If you can’t repay the balance when asked, the bank has the right to foreclose on your home to get its money back.

Let’s say that your housing market goes down and the amount of equity in your home drops simultaneously. You house used to be worth $350,000 but now it’s only worth $250,000. Effectively , you’ve lost $100,000 worth of equity in your home. The bank may get nervous because their loan to you, in the form of the HELOC, is no longer backed by an asset that can fully repay the outstanding balance. The bank may decide to cut its losses, which means that they will demand full repayment of the outstanding loan balance. Should you not repay that balance, then the bank can proceed to foreclosure in order to get its money back before all of the equity in your home disappears due to market conditions.

HELOCs facilitate the siphoning of your home equity in dribs and drabs

When you use a HELOC, you are spending the equity in your home instead of increasing it. You are increasing the debt owed on your home each time you spend its equity.

One of the most dangerous ways to use a HELOC is to have it attached to your debit card. There is nothing stopping you from spending your home’s equity on mundane items. Think of trips to the coffeeshop, to purchase concert / sports tickets, to buy clothes, to finance your daily life. If you need a HELOC to survive from on paycheque to the next, then you’re living above your means. You’re working your way into a severe debt trap. Figure out how to free yourself and stop digging a bigger debt hole.

If there is ever a good use for a HELOC, it’s to make major repairs to your home that are required for your safety, i.e. replacing the furnace or the roof.

There is nothing wrong with you spending your home equity on the costs of your daily life if you need to. Just don’t do it via a HELOC! The wiser course of action is to sell your house and get the cash. That way, the entire amount of your home’s equity is available for your life’s expenses. You won’t be paying interest and fees to the bank for the privilege of spending your own money. You won’t run the risk of foreclosure. You won’t be indebted to the bank. And the money is still yours to spend as you wish.