The article “How Much Debt Is Too Much? How To Figure Out If You’re Taking On More Than You Can Handle” was originally published on Financial Post on September 29, 2020.
The government is racking up debt, but that doesn’t mean households should too
Following last week’s throne speech, it seems that federal spending is likely to increase and that means further increases to the federal debt. Net federal debt was forecast to approach 50 per cent of GDP in fiscal 2021 but could be closer to 60 per cent with potential new spending.
Combined with provincial debt, we could soon exceed 85 per cent of GDP. In the 1990s, when interest rates were much higher, federal and provincial debt levels were more than 90 per cent of GDP and led to credit rating downgrades and several years of austerity measures prior to the 2008-2009 financial crisis. Credit rating agency Fitch recently downgraded Canada’s rating from AAA to AA+ in June.
Debt is a double-edged sword. It is a common and necessary tool used by governments and corporations, but for individuals, debt is a four-letter word that is financially frowned upon. So, at a time when the government is spending much more than it is bringing in, it raises the question: how much personal debt is too much?
Canada’s household debt as a percentage of disposable income has ranged from 170 to 175 per cent for the past four years, an historic high. It dropped drastically in the second quarter to 158 per cent, marking the first significant decline in a generation.
One thing that makes debt a challenge for individuals is that most people will not work their whole lives to be able to cover their debt payments. Governments and companies can borrow differently than individuals because governments and companies do not retire.
Governments can often borrow at lower rates than consumers. Governor General Julie Payette addressed this in the throne speech, saying, “Canadians should not have to take on debt that their government can better shoulder.”
Mortgage borrowers are generally limited by gross debt service (GDS) and total debt service (TDS) ratios. Gross debt service is equal to principal and interest payments plus property taxes and heat divided by gross annual income. This debt ratio cannot exceed 35 per cent of income. TDS adds in other debt obligations to the calculation, so that total debt service cannot be more than 42 per cent of income.
With fixed and variable mortgage rates both under 2 per cent, it means borrowers can qualify for and service higher mortgages than ever before. However, since 2018, there is also a mortgage stress test that requires qualification based on a higher interest rate as well. Right now, that rate is 4.79 per cent.
Effectively, the government wants Canadians to stress test their borrowing capacity based on the risk of higher rates when their mortgage comes up for renewal.
An individual or couple with a total income of $100,000 and a $25,000 down payment may be able to qualify to buy a home for about $500,000 currently with a five per cent down payment. With a larger down payment of $120,000 or 20 per cent, their home purchase price could be more like $600,000.
In many Canadian cities, prices have risen considerably in recent years and so have borrower’s mortgages. In some cases, borrowers are never really reducing their debt. This may be due to moving to more expensive homes as their families and down payments grow. Or this may be due to use of secured home equity lines of credit that can be accessed and spent as home equity increases or as mortgage principal is paid down.
Conventional financial planning advice suggests that you should aim to be mortgage-free by the time you retire. The reality is that some of today’s big city borrowers will never pay off their mortgage. That may be acceptable if there are both exit and contingency plans.
Some families may live in a large home with a large mortgage and plan to downsize that house once they are empty nesters or upon their retirement. This may be a reasonable exit plan.
A contingency plan for that big mortgage is different. Last week, I took my children to the dentist and I also got my hair cut. Who ever would have thought a year ago that both of those businesses would have been shut down for a couple months? It goes to show you that anyone’s job can be at risk at any time.
The risk for heavily indebted borrowers regardless of their line of work is that due to job loss, disability, or even death, their debts become unmanageable for their families. Disability and death can be mitigated by purchasing insurance, but job loss can only be mitigated by not taking on too much debt in the first place. Borrowers need to have savings or borrowing capacity to cover a short-term reduction in income or increase in expenses, especially given how expensive the transaction costs can be to buy and sell a home.
A $1-million home purchase and sale in Toronto, for example, costs $32,950 in municipal and provincial land transfer taxes and up to $56,500 in real estate commissions. That amounts to almost 9 per cent of the home value without factoring in legal fees, moving costs, or a mortgage prepayment penalty.
Some borrowers are banking on an inheritance. Those with a sense their parents may leave them something in their wills may notionally borrow against that future inheritance. There are obviously risks with this approach given seniors are living longer, the cost of long-term care is rising, and there are no inheritance rules in Canada like in other countries that give children a claim on their parent’s estate.
My advice to borrowers is to consider their mortgage approval from the bank as just one guideline in setting borrowing and home purchase limits. Personal finance requires personalization and while one borrower may be able to maximize their debt capacity, another may need or want lower debt payments. It may be a personal choice to be conservative, or it may be based on other expenses.
Someone may have health problems and an expensive prescription. They may have a penchant for travel or goals to start a business. Maybe they want to or need to consider a private school for a child who is struggling or may require specialized assistance.
Before taking on debt, borrowers should make sure the resulting debt payments will not interfere with other short and long-term financial goals, including when interest rates rise. Professional financial planners can help, but even on your own, you can evaluate income, expenses, debt service, and savings to try to set reasonable and personalized parameters.
Any borrower who has high-rate consumer debt like unsecured lines of credit or credit cards should reconsider their spending and even their home ownership if their high housing costs are the thing causing them to fall behind.
Despite the financial industry’s encouragement to save and invest, some borrowers should be paying down debt instead. Paying down debt that is at higher interest rates like unsecured lines of credit or credit cards may be better than investing. Avoiding that interest may provide a higher guaranteed rate of return than you could otherwise earn on your investments.
Savers with low tax rates that may benefit less from RRSP deductions or investors with a low risk tolerance may also be better off repaying debt over investing.
Despite low interest rates, all borrowers — whether first-time homebuyers or federal governments — need to plan for higher interest costs in the future. Debts that may be manageable now may become less so when borrowing costs increase. Rising financing costs could impact everyone’s ability to spend on other things at some point down the road.
The risk of higher rates in the future is one thing that is leading to opposition to federal and provincial government borrowing today. That same risk, amongst others, is another reason to borrow strategically to avoid taking on too much debt yourself.
Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto, Ontario. He does not sell any financial products whatsoever.