Do we really have too much debt?

Are Canadians carrying too much debt? Ask that question with a straight face and you’re likely to get an answer like, “Well, duh. Obviously.” Household debt at record levels. Big mortgages. Lines of credit. Savings rates near zero. The list goes on. But what if that’s not the whole story?

Turns out that if you scratch the surface of those gloomy headlines, the situation is not as bad as they suggest. As CIBC economist Avery Shenfeld noted recently, much of the growth in household borrowing is coming from those who already have high debt burdens, not “less indebted families getting drawn to the punch bowl by the promise of low [interest] rates.” According to Roger Sauvé, president of People Patterns Consulting and author of an annual report called The Current State of Canadian Family Finances, only about one million of Canada’s 14.5 million households have crushing debt problems. Most of us are doing OK.

Before we pat ourselves on the back, we do tend to be overly comfortable with debt. We use plastic or lines of credit not only for emergencies, but also for big-ticket expenses and impulse buys. Our mortgages are much larger, especially if we live in big cities. Yet most of us handle debt responsibly: we borrow at low rates, pay on time and have realistic expectations. The people getting into trouble are those who forget that side of the equation.

“There is nothing wrong with debt, and not everyone is borrowing too much,” says Stephanie Holmes-Winton, a Halifax financial adviser and the author of $pent. “We don’t want to panic people, but we also don’t want to give them a get-out-of-jail-free card. Problems begin when we don’t have a plan to pay it back, when we don’t understand what type of debt is most suitable for our situation, and when we can’t control our spending and end up borrowing too much.”

In other words, we should stop looking at debt in isolation and instead consider the bigger picture, including the variables that could leave us financially vulnerable.

The ratio that won’t go away

Today it’s impossible to read a news story about family finances without coming across the same alarming statistic: Canadians’ overall debt-to-income ratio is now 151%, higher than ever. Thanks mainly to bigger mortgages and the popularity of home equity lines of credit, that means for every $100 we earn, we now owe a staggering $151. In 1990, we owed 90 cents for every dollar we earned.

Roger Sauvé says there’s a direct correlation between this ratio and the growth of consumer bankruptcy. According to his most recent report, released in March, the rate of insolvency is up 139% since 1990.

But while a 151% debt-to-income ratio looks grim, it doesn’t offer a complete picture of a family’s financial health—not even close. To begin with, the ratio treats all debt equally: it doesn’t matter whether you’re paying 30% interest on your department store credit card or 3% on the mortgage for your modest bungalow. It makes no distinction between bad debt and good debt.

Another problem with the ratio is it disguises the actual dollar amounts of both the debt and the income. Who’s in better shape? Is it Sharon, who earns $100,000 a year and has a $150,000 mortgage on a house valued at $500,000 and no other debts? Or is it Ken, who earns $30,000, has no assets, and owes $45,000 on his credit cards, his car loan and other consumer loans? Both have debt-to-income ratios of 150%, yet Sharon is in excellent financial shape while Ken is flirting with bankruptcy.

A history lesson

You also need to consider our rising debt-to-income ratio in historical context. Back in 1990, a typical Canadian home cost about 3.4 times the average income, and mortgage rates were between 12% and 14%. Borrowing was incredibly expensive, especially when you could put your money in a savings account and earn a safe 10% (inflation was about 5%). Back then, a debt-to-income ratio of 151% would have been unmanageable—and irresponsible—for most families.

Today the situation is completely different. Now it takes five times the average income to buy a house, so families who want to own a home may have little choice but to take on bigger mortgages than their parents did. The good news is they can usually afford to do so: with mortgage rates as low as 3% or 4%, borrowing has never been cheaper, and in many parts of the country house prices have appreciated at double or triple that rate. Meanwhile, with inflation at about 2.5% for the last couple of years, putting money in savings accounts now guarantees you’ll lose purchasing power.

All of which is to say that our higher debt-to-income ratio today does not necessarily mean we’ve turned into a generation of reckless spendthrifts. As long as families control their other expenses and chip away at their debt every year, they’re not necessarily in jeopardy.

“Some people have big debt-to-income ratios because of big mortgages, but they can handle it because they’re unbelievably frugal in other areas of their life,” notes Janet Freedman, a fee-only planner with Toronto-based Finance Matters. “They don’t have a car, don’t go to restaurants and don’t have a lot of discretionary expenses.”

While many young people are starting their working lives with more debt, the ones with more education and higher incomes may also have the tools to pay it off. Consider Rubina Ahmed-Haq and Ron Haq, who two years ago had a debt-to-income ratio of 226%. The Haqs, who are expecting their first child, took out a substantial mortgage to purchase a townhouse in Mississauga, Ont. (The thirtysomething couple had no other debts.) Today, they have paid off $80,000 of that mortgage, cutting their 22-year amortization to 13 years. That’s brought their debt-to-income ratio down to 190%. It’s still much higher than average, but it’s moving steadily downward. “Our focus is on paying the house down and having less debt every month,” says Rubina, a business journalist.

How did they do it? First, they resisted borrowing the maximum offered by their bank, which would have pushed their budget to the max. Banks typically approve a mortgage as long as your housing costs, including property taxes and heating, make up no more than 32% of your pre-tax income. But experts recommend keeping this “gross debt service ratio” under 30%—and you may want to keep it to 25% or lower to account for unforeseen expenses. If you don’t include their optional payments, the Haqs’ gross debt service ratio is only 13%.

The Haqs also took advantage of low interest rates. When the banks presented bargain-basement rates in early 2011, they locked in at 2.99%. They also pay much more than they have to: the Haqs’ payments are about equal to what they would be if their rate was 8%. Not only does this reduce their mortgage much faster, it builds in plenty of wiggle room in case interest rates rise (and we know they will eventually). Even if rates are 3% or 4% higher when the Haqs are ready to renew, they won’t experience any sticker shock.

Rubina says their goal is to stay in the home long after the loan is paid off. “Many people instead upsize their house, and they’re back where they started debt-wise.”

Gail Balfour knows all about starting over. The 43-year-old had only $84,000 left to pay on her Toronto condo last July, but she wanted to upgrade to a house. Most of the homes in her price range were in appalling disrepair, infested with mould and dangerous wiring. “I could have just paid off my condo and moved to an area that’s more affordable, but at the end of the day my life is here,” she says.

Finally, she found a promising townhouse listed in the mid-$400,000s and decided to take the plunge. She sold her condo for $279,000, put a 30% down payment on the house and signed on for a mortgage with a 30-year amortization. Less than a month later, Balfour realized her newly installed dryer was venting into the attic (a building code no-no), and she needed to replace a busted central air conditioning unit. So she found herself plopping down the credit card to get these things fixed.

Still, despite all of her new debt, Balfour feels it’s under control. She doesn’t want to have a mortgage in her 70s, so she’s making optional extra payments that should cut the amortization in half. “It helps that I am paying a variable rate that is crazy-low at 2.1% right now,” she says. “That could change quickly and mean a significant increase in my monthly expenses.” But like the Haqs, Balfour has built in a buffer: if rising interest rates put pressure on her, she could just reduce the optional mortgage payments she’s making now.

Room to breathe

Will and Theresa Huber can tell you all about the importance of having some breathing room when it comes to debt. For several years, the Hubers (we’ve changed their names to protect their privacy) have wanted to purchase a larger home for their family of five. Will and Theresa, both in their mid-40s, bought their 1,600-sq-ft, three-bedroom abode back in 1996. When a bigger house in their Burlington, Ont., neighbourhood became available in 2008, they wondered if they should dive in. With only 17% of their $200,000 annual income going towards housing costs and enough money to consistently contribute to RRSPs and RESPs, they could have managed. Still, Will worried about the stability of his high-tech sales position and they decided to stay put.

That turned out to be a wise decision. Will’s firm went bankrupt in late 2008, and while he found another sales position five months later, it was at considerably less pay. Then last year, Theresa got downsized from her part-time position at a software company. She now works part-time at a retail store for slightly over minimum wage.

Today the Hubers’ net income is $2,000 a month less than it was before, and it’s been a big adjustment. “We’re living paycheque to paycheque, plus or minus a few hundred dollars a month,” Will explains.

The Hubers are in a difficult situation, but it could have been a lot worse had they not been living well below their means before the job losses. Had they bought that bigger house, they estimate they’d be spending an additional $1,000 on mortgage payments, property taxes and utilities. That’s another $1,000 of cuts that would have had to be made from their budget, which is impossible for the Hubers to fathom. Will says it might have forced them to tap their RRSPs to avoid having to sell the house.

Driven to disaster

While bigger mortgages may be a fact of life these days, there’s less excuse for the debt we’re piling up to buy other things—especially things with wheels.

Stephanie Holmes-Winton always looks at car loans when her clients complain about cash flow problems. If a couple is leasing or financing two cars, those payments might easily exceed their mortgage. “Car payments seem to be what push people over the edge, and my bankruptcy colleagues find this, too,” she says. According to Equifax Canada, the amount that Canadians owe on auto loans and leases has grown 10% since the first quarter of 2011. “I say, ‘Do you realize you pay $1,400 for your cars and only $1,200 for mortgage payments each month?’ Sometimes it helps when you put it to people that way.”

Holmes-Winton likes the 36-month rule: she says if you can’t pay off a car loan in that period, then you’ve bought more car than you can afford. If you stick to that rule and keep the car for another five or six years, that allows you time to save for your next vehicle.

Duncan Inglis of London, Ont., knows all about getting into debt trouble with cars. When his 11-year-old vehicle recently died, he purchased a new car that’s costing him dearly: he forked over $15,000 and took out a loan that will cost him $350 a month—with seven years remaining. Eight months later, his wife, Shari, had an accident with her own car and the damage was deemed unfixable. The Inglises borrowed another $12,000 to purchase a replacement, and now Shari will pay $240 a month for four years. “That put us further into consumer debt with the two loans,” says Duncan, a 40-year-old business resources officer.

The Inglises spend 35% of their $107,000 combined incomes servicing their mortgage (currently at $148,000), cars and credit card debt. Throw in child care, food and other necessary expenses, and there’s no money left at the end of the month. “I feel like I’m not getting farther ahead,” he says.

The Inglises are right to be concerned. They are nearing the red zone that economists warn us about. Canadians who spend 40% or more of their incomes servicing debt are on the road to financial trouble: these are the one million households we mentioned earlier. If the Inglises were to suffer a job loss the way the Hubers did, they might well be pushed over the edge.

Do your own stress test

How can you know whether your own debt level is too high? One useful stress test is to consider what would happen if interest rates rose two percentage points. If you have a $200,000 mortgage and your rate is 4%, you’re paying $1,052 a month, assuming a 25-year amortization. Increase the rate to 6% and you’d be paying $1,280, an extra $228 a month. Could you afford that?

According to a BMO study released in March, 20% of Canadians said a 2% increase in mortgage rates “would hamper their ability to afford their home.” Another 23% were unsure how a rate hike would affect them—which suggests they haven’t given this crucial question enough thought. Duncan Inglis is no exception. “Yikes, I’m not sure,” he says. “I would certainly make the appropriate adjustments—dropping all extracurricular and entertainment expenses—if it became necessary to maintain a roof over our heads.”

Then think about how you would cope with a job loss. The Hubers are surviving because they didn’t spend all of their income before, but families who are already stretched to the limit won’t stand up so well. An emergency fund that covers several months of expenses can make all the difference.

Ask yourself hard questions about your discretionary spending, Holmes-Winton suggests. This includes everything from eating takeout to going to the movies or buying things for your child. To monitor this spending, she puts clients on a weekly cash budget for 60 days—but she doesn’t tell people how to allocate the funds. “I let them figure it out. If I point it out to them and rub their faces in it, it doesn’t change anything. It just makes them feel ashamed.” She finds the exercise helps people learn to prioritize what’s truly important.

Finally, do you have any savings at the end of the month? Are you able to comfortably pay your debts, and not just the minimum amount required? Inglis is frustrated by the lack of cushion in his debt payments and has decided to take action. If he can’t rein in his spending, he wants to earn more money: he’s considering a flyer route.

So, are we in too much debt? For the average Canadian, the answer is no. But as Roger Sauvé says, for every one of us who is fine, there is someone else barely hanging on. “We can’t say everything is great, because the trends say otherwise. Debt is trending upward and as a society we are becoming more vulnerable.”–by Deanne Gage