A low interest rate environment is used to stimulate the economy by encouraging consumers to spend. For example, the overnight lending rate which drives the interest rate on variable mortgages and lines of credit, is currently at 1.00% compared to the 10-year average of 2.38% [i]
Consumers have responded to the low interest rate environment by taking on more debt through mortgage loans, credit card debt, and short-term loans. The question we need to ask ourselves is, with mortgage rates in Canada so low right now, are we capable of servicing our debt obligations if interest rates increase over the next few years?
This matter has caused the Bank of Canada Governor Mark Carney to issue a warning. He states that although our economy is doing relatively well, consumer debt has been increasing over the past decade.
“Canadian households increased their borrowing significantly. Canadians have now collectively run a net financial deficit for more than a decade, in effect, demanding funds from the rest of the economy, rather than providing them” [ii]
In other words, Canadians devote too much money to household spending, while not enough is coming back to fuel the economy. And that could negatively impact us going forward.
According to CMHC, in recent months, Canadians have started to cool their borrowing habits. What is unclear is whether consumers started to rein in their debts or just hit their capacity to borrow. The CMHC report says the slowing of consumer debt can be attributed partly to the cooling of the housing market. Consumers needed to curb their borrowing sooner rather than later, since the average Canadian household debt-to-income ratio is 13 percentage points higher from where it was before the financial downturn.
Currently the average Canadian household owes $1.53 for every $1.00 of income, the highest it has ever been. Of that number, mortgage debt accounts for the largest portion.[iii] However, what needs to be established is the percentage of income that is being used to service the debt payments. According to CIBC’s deputy chief economist, Benjamin Tal, assuming 30% of your income is going towards debt obligations, which is an acceptable ratio, there is no guarantee that it will remain at 30% tomorrow. What consumers need to understand is their financial risk in the event of a rate increase. Essentially, how much will a rise on interest rates affect their ability to pay their debt? [iv]
Consumer debt can be broken into mortgage loans, lines of credit, term loans, and credit card debt.
The good news is that according to TransUnion data from the Globe and Mail, the rate of debt on term loans, credit cards, and lines of credit have been slowing down. Credit card debt has actually fallen 2.65% from where it was in 2010.
The bad news is that mortgage debt has not slowed. As mentioned by Rathub, a decent sized portion of mortgage holders are carrying mortgage debt into their 70s. According to the annual CAAMP report, three percent of mortgage holders (160,000 people) indicated they have no room for a rate increase on top of their current costs. That number is noteworthy, but the 650,000 Canadians (or 12% of mortgage holders) that would be challenged by a rate increase of less than 1% is much more concerning. If mortgage rates were to increase in the near future, more than half a million Canadians would struggle to service their debt – that’s enough people to affect the economy.
What’s the silver lining? We are expected to remain in a low interest rate environment for the next one to two years so lenders are not likely to appreciably increase their debt servicing payments during that time, says Tal. That will allow time for people to pay off their debts.
Benjamin Tal also points out the difference between Canada and the US. He says, “Quantity is not enough, you need to discuss quality”. He goes on to say, “People have to realize that the U.S. housing market crashed not because of the 150-per-cent debt-to-income ratio, but because it was a lousy 150-per-cent ratio.” And it appears that Canadian debt, specifically, mortgage debt is manageable. From the CAAMP study mentioned above, almost 8 out of 10 (78%) mortgage holders have at least 25% equity in their home, which is a good thing.
Another indicator of good debt manageability can be found in credit scores. “The high average credit score demonstrates a strong ability among homebuyers with CMHC-insured mortgages to manage their debts”, says CMHC.
In summary, Canadians have acquired more debt than they ever have in history, partly due to the low rate environment that has been incentivizing them to borrow more. Mark Carney, Governer of the Bank of Canada has expressed his worry in the ability of Canadians to repay their rising debt if interest rates were to rise. Fortunately, with most economists expecting Canada to remain in a low rate environment for the next one to two years, time is on our side. The situation isn’t quite as dire as it seems because Canadians have high average credit scores, maintain healthy home equity, and have started to rein in their debts.