- June 10, 2019
7 Loan Myths Among Families of Wealth
Families and individuals with a significant level of wealth sometimes hold misinformed assumptions regarding their creditworthiness and ability to qualify for a loan. For example, many people believe that an unused line of credit improves their credit profile. It can actually do the opposite. Others assume that cash flow isn’t important because they have significant liquid assets. The truth is most lenders look first for recurring income when determining creditworthiness, and then look to money in the bank and other assets.
Those are just a couple of the commonly held misconceptions regarding lending. In the following, Mark Foster, Head of Banking and Credit Advisory, sets the record straight about what is myth and what is reality.
I’m a guarantor on a loan that is being paid for directly by the borrower, so that shouldn’t affect how a bank views my creditworthiness.
Loan guarantees absolutely can affect how a bank views your creditworthiness.
“Lenders can and do analyze loans that are guaranteed and will take that ‘contingent liability’ into account when determining creditworthiness. That may affect the guarantor’s ability to get additional debt,” Foster explains.
For example, say someone owns a collectible coin business that has taken out a business loan. In order to be approved for that loan the owner had to personally guarantee it. If the business can’t pay back its debt, as a guarantor, the owner would be responsible.
“Even though a guarantor isn’t liable for making payments unless the borrower defaults, lenders can consider the likelihood of that possibility when evaluating the guarantor as a borrower,” Foster says. “But not all lenders are the same. Some make adjustments for all loan guarantees. Others may only make adjustments if the borrower can’t show the ability to repay. It’s important to be aware of that possibility when providing a guarantee.”
Banks only look at actual debt outstanding on a line of credit as opposed to total credit available.
Many lenders look at lines of credit as if they are fully utilized, whether or not the line is used at all.
Consider someone who has an unused home equity line of credit. A lender may evaluate them assuming the line is maxed out and factor the theoretical payment into their overall debt service. In other words, while someone may view unused lines of credit as additional liquidity, a lender could view them as a reduction in the ability to pay additional debt.
“Sometimes people think that adding lines of credit gives them flexibility. It makes them feel secure. But the very things that give you comfort can actually impair your ability to obtain other credit,” Foster says. “Banks don’t typically look at unused line of credit availability as a good reason to approve a loan. They don’t give you credit, literally, for that.”
Foster adds that maintaining unused lines of credit do have their purpose, in that they provide flexibility to quickly access cash when needed. It’s just important to be aware that they can make obtaining additional credit more difficult.
All sources of cash flow are weighed equally by lenders.
Income received from investments and business partnerships for example are often not considered the same as a salary to a bank.
“Most lenders like to see cash flow that they consider reliable, such as salary or interest income,” Foster says. “Income from private companies or capital gains are considered more volatile and have a lower probability of being consistently generated year after year. Even with a track record of successful trading activity, it is difficult for lenders to give capital gains much weight. Income from a privately held company has a better chance of being considered, but you need to work with a lender with the sophistication and willingness to understand the income source.”
Cash flow isn’t important for an individual with high levels of liquidity.
Income almost always matters more than how much money someone has in the bank. Banks and other lenders care more about seeing income that is reliable, recurring and sufficient to support a borrower’s obligations.
“Many banks consider themselves cash-flow lenders first, meaning they lend primarily based on recurring income,” Foster explains. “You could have millions of dollars sitting in cash, but if you are not actively generating recurring income to service your debts, banks can still have an issue with granting credit. Liquid assets can be used as a reason to extend credit where cash flow is insufficient, but it doesn’t have as much weight as you might think. This is not to say that maintaining high levels of liquid assets hurts you – far from it. But cash flow is usually the main driver in a lender’s analysis.”
Credit scores don’t matter to lenders when you have a high net worth.
Credit scores do matter in the eyes of bank, regardless of a borrower’s net worth – but not necessarily how you might think.
“Your credit score is a representation of how you’ve repaid past and current consumer debt obligations,” Foster says. “For basic consumer transactions, such as a residential mortgage or credit card, the more likely it is that a good credit score is going to help you. However, for “tailored credit” (larger, customized loans extended to high-net-worth-clients by wealth management firms), a good credit score is rarely a material positive driver. Often those loans aren’t reported to credit bureaus anyway.”
However, in both consumer and custom credit situations, a poor credit score will likely hurt you.
“It’s surprising how often you find high-net-worth individuals with low credit scores. Sometimes it’s the distractions of wealth that diverts focus from diligent bill paying. Or a principled stance on not paying a medical bill believed to be incorrect. Sometimes it can be because of identity theft or a byproduct of divorce.”
For consumer loans, a low credit score will almost always have a negative impact, regardless of a person’s wealth. At best it requires an exceptional approval. At worst, a person could be denied credit. But it also can affect custom credit. Risk managers will see a low credit score as a red flag and may require additional information or changes to the terms of the loan. An unsecured loan request under these circumstances can be particularly difficult.
Foster gives the example of someone with a nine-figure net worth and very low debt who was seeking an eight-figure secured loan for an investment. Three years prior on bad advice from an advisor the person had given the keys back to a lender on a house that was underwater. The “savings” achieved from this was insignificant compared to the person’s net worth, but unfortunately it also created a low credit score and a red flag to the lender. It almost killed the deal and caused several weeks of delay to approve.
“Regardless how large your balance sheet is, if you don’t maintain a good credit score – or work hard to repair a damaged score – you can expect difficulties when accessing credit,” Foster said. “Focus on improving your score and having detailed explanations for any negative items to minimize the impact.”
Obtaining a large unsecured line of credit (a loan without collateral) improves a person’s credit profile and attractiveness to lenders.
The existence of a large unsecured line(s) of credit can have a uniquely negative impact on your financial profile.
“I’ve seen individuals aggressively looking to establish a large unsecured line, partly for its utility, but also because they viewed it as a badge of creditworthiness. Essentially these were ‘ego lines,’” says Foster. “The problem is they didn’t fully understand the limitations they were putting on themselves.”
As mentioned previously, lenders typically analyze unused lines as if they are fully used. For unsecured lines, lenders also assume it is being paid back in 3-5 years, and add to your actual debt service that theoretical principal payment. The larger the line of credit, the bigger the impact on your ability to qualify for additional debt.
For illustration, a $10,000,000 unsecured line that isn’t being used can add over $2,000,000 a year to your total debt payments in a lender’s analysis.
“It doesn’t stop there. Banks typically require the borrower to maintain liquid assets of one to three times the unsecured loan amount at all times,” Foster explains. “It is important to understand the effect that unsecured credit can have on your ability to obtain additional credit and plan accordingly.”
Being the beneficiary of a large irrevocable trust makes the beneficiary more creditworthy to a lender.
Beneficiaries to a sizable irrevocable trust often don’t have the borrowing power they believe they should have. Only when the trust itself is party to the loan do they receive full “credit” for the strength of the trust.
Trusts have rules that dictate when and how and to whom they pay distributions, and sometimes give significant discretion to the trustee for making other payments not scheduled. A bank will usually underwrite only what is specifically set to be disbursed or has been disbursed historically.
“Banks can’t force a trustee to make discretionary distributions for their own convenience,” Foster concludes. “Discretionary distributions are tough to underwrite against. Usually, the better they know you, the more flexibility you’ll get.”
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