October 13, 2014
Kevin is a 27-year-old Vancouver resident who makes about $50,000 a year as a graphics designer and has $520,000 worth of debt — an amount he feels quite at peace with.
Even someone with a lot of assets can still be carrying too much debt — the amount has to mesh with your ultimate financial goals. Take Juliana, not her real name, a single, 52-year-old Torontonian hoping to retire in eight years
This amount is made up of a $200,000 mortgage on his home, $200,000 in agriculture loans for a farm that he rents out, $70,000 on his line of credit and $50,000 in margin loans or money borrowed from a brokerage to invest.
“If I don’t accumulate enough debt I won’t be able to buy all the things that I want, leverage my investments for growth, and enjoy a meaningful life,” he says. “It allows me to take advantage of cheap credit to fund my hobbies and lifestyle choices. But at the same time it gives me an adequate margin of safety so that I can manage my debts in a safe and controlled manner.”
Canadians have increasingly become more comfortable with debt. Despite the Bank of Canada repeatedly sounding the alarm about household debt levels, calling it the biggest domestic risk facing the Canadian economy, we continue to take on more. But how much debt is too much?
“It depends,” says certified financial planner Jason Heath. “You may have a young lawyer who just graduated from law school with student debt who is suddenly making $300,000 a year and has a big mortgage that he can blow out of the water in 10 years. It might not be a good comparison relative to someone who is self-employed in a volatile industry and who doesn’t know how much money he’s going to make next year.”
If I don’t accumulate enough debt I won’t be able to buy all the things that I want
But there are rules of thumb, or guidelines, that can help determine how healthy your situation is or where you stand. You can start by comparing your debt with the average Canadian’s.
Statistics Canada says that the average level of household credit market debt to disposable income was 163.6% between April and June. That means we owe almost $1.64 for every $1 that we make. Kevin, who asked that his last name not be disclosed, has a debt-to-income ratio of about 1,000%. Economists have said that a more stable ratio would be between 110% and 120%. The ratio was closer to those figures in the early 2000s when the economy was on firmer ground, says Cris deRitis, senior director at Moody’s Analytics.
But consider these two scenarios. A woman who makes $100,000 a year and has a $164,000 outstanding mortgage on her huge Vancouver home versus a man who earns $25,000 a year and owes $41,000 on his line of credit and on credit cards. Both have debt-to-income ratios of 164%; but who is better off?
Obviously, not all debt is equal; the composition of your debt is key to understanding where you stand.
“From an investment perspective, I consider good debt to be real estate or education. Bad debt would be any other consumer debt. Car debt is an inevitable debt that is neither good nor bad,” Mr. Heath says. “From a tax perspective, bad debt would be money borrowed for a non-invested purpose: your house, student loan. Good debt would be money borrowed for an investment purpose: to buy a rental property or invest in a business or stocks and bonds because the interest is tax-deductible.”
As a general rule, your debt load (housing costs, car loans, credit card payments, etc.) should not exceed 40% of your pre-tax income.
“If you’ve got a student loan [and you're paying] $10,000 per year and you make $50,000, that’s consuming about 20% [of your income] already and if you take a mortgage on top of that, it shouldn’t [add up to] be more than than 40%,” says Michelle Snow, associate vice-president of retail products at TD Canada Trust.
To grant you a mortgage, financial institutions also want to see that your housing costs (mortgage payments, property taxes, condo fees, etc.) will be below 32% of your gross income. It’s getting tougher to come under this ratio as housing prices have ballooned. The typical family in Vancouver would need to spend 62% of income on mortgage payments to buy a bungalow, a report Friday from BMO suggests. This jumps to 75% if rates were 2 percentage points higher. In Toronto, it would take 42% of income currently, moving up to 50% if rates were to rise 2 percentage points.
“Thirty years ago, the average house cost three times the average family’s income and now it’s something like seven or eight times; so the cost to purchase a house relative to income, that ratio has gone up hugely,” Mr. Heath says.
While households in the U.S. have been shrinking their debt levels since the financial crisis, Canadians are borrowing more. “Macroeconomic shocks like rising interest rates, a labour market slump or falling house prices could pose a serious threat to the solvency of highly indebted households,” an Allianz Global Wealth Report warns.
Despite the warnings, our total lending volume rose by 4.4% in the course of the year, reaching historic per capital debt levels, the same report said. Also, years of low interest rates — five-year closed insured mortgages are now below 3% and variable rates fell under 2% this year — have lulled us into a sense of security.
“A lot of people forget that as recently as the summer of 2008, the prime rate was 6.25%,” Mr. Heath says. “People need to envision: Here’s what will happen if my mortgage is at 5%.”
Moody’s Analytics predicted this week that interest rates will remain the same until the end of this year and rise next year. The Bank of Canada’s overnight interest rate is forecast to rise to 1.5% by the end of next year from 1% now, where it has stood for four years, according to a Bloomberg survey of economists.
Even a 2% increase in interest rates would spell disaster for many Canadians. A BMO survey released in March reported that, 20% of respondents felt a 2% increase “would hamper their ability to afford their home.”
Even a slight change in the interest rate will push thousands into bankruptcy, adds Frank Bennett, a bankruptcy insolvency lawyer and author of Bennett On Consumer Bankruptcy.
In 1984, there were 22,022 consumer insolvencies; in 2013, there were 118,678, he says.
“What we’re seeing is approximately 10,000 consumers going bankrupt a month in Canada,” he says. “They’re paying exorbitant interest rates on credit cards and household debt. They’re using one credit card to pay another and they’re out of money by Friday night. What you’re seeing is people treading water, they’re just hanging in there and if any one in a couple gets sick or has a problem and stays away from employment, the deck of cards collapses.”
He says to make sure that you have a contingency plan; consider what happens when one person in your household loses his or her job or gets injured and cannot work. Who will continue servicing your debts and paying your bills?
Kevin, with his 1,000% debt-to-income ratio, has done the math and stress-tested his personal finances. “I have emergency liquidity from moving my investments around and selling assets. If interest rates were to increase I will simply lower my debt-to-net-worth ratio,” he says. “The key is to be flexible and have a solid understanding of one’s unique financial situation.”