Debt: The Good, the Bad and the Ugly

There have been many news articles in recent months highlighting the concerns of federal government finance officials regarding Canadian household debt and the increase in the debt to income ratio to record breaking levels. This ratio currently stands at 165 % which means that the average Canadian household now owes $165.00 for every $100.00 of disposable income. This article will address the following questions which must be asked:

How Has This Situation Developed?

Household debt has increased substantially and rapidly in Canada and many other countries. Although there are any number of contributing factors to this debt problem, there are two villains in particular that have caused the dramatic surge in household debt:

One can be attributed to government fiscal policy. In order to stimulate the post-recession economy interest rates have been maintained at historically low levels for an extended period of time. In Canada, interest rates have been artificially low for over two years with the benchmark rate currently at one percent. Enabled by such low borrowing costs, consumers have gone on an unprecedented spending spree, buying up products and goods of all manner including big ticket items such as houses, cars, recreational vehicles, furniture, electronics and vacations. This massive spending has been possible because the low interest rates have made it affordable for those who are only concerned about the monthly payment.

The other villain of course is the consumer. We live in a society where many of us have the “want it now” attitude often referred to as instant gratification. The concept of deferred gratification where a person saved in anticipation of a major purchase was once the norm with our parents and even more so with our grandparents. However that is now rarely the case. Many blame the financial institutions and large corporations who make credit so easily available while others blame glitzy marketing campaigns for enticing them to purchase products that they may want but oftentimes do not need. Ultimately we must accept much of the blame ourselves for signing on the dotted line. Admittedly there are some cases where the householder is faced with little choice other than using credit to pay the bills and to avoid using retirement savings which is a last resort. This strategy can be effective depending on the level of debt and the household income. However in the vast majority of cases it is our excessive borrowing that has caused the debt problem and the finger cannot be pointed elsewhere.

Why is it a Concern to Federal Finance Officials?

Federal finance officials are concerned for good reason. It is widely recognized that record consumer spending has greatly contributed to the post-recession economic recovery and this is a good thing. However it is a double edged sword. The downside is that as consumers become bloated with debt they will inevitably reach the point where they are unable to service additional debt payments, resulting in reduced consumption and spending. Adding to the concern is the fact that interest rates have nowhere to go but up which would cause an increase in delinquency rates as some consumers become unable to meet their payment obligations. All this would place negative pressure on the economy resulting in a possible return to recessionary times and ultimately higher unemployment.

Why Should it Be a Concern to Individual Households?

Consumers themselves must also be very concerned about their spending and borrowing. As noted earlier, the current low interest rates have made borrowing attractive and easy because the payments are lower and more affordable and if the only concern was the monthly payment that would be fine. However there are other issues at play that many of us are either unaware of or do not consider. The big one is the inevitable rise of interest rates. This will likely happen in the coming year or two as the global economy improves, resulting in elevated levels of inflation. Increased interest rates will herald the beginning of major problems for some consumers. The most dramatic example can be drawn from a real estate mortgage.

Let’s take the typical case of a household that has borrowed $350,000.00 to purchase a house. If the interest rate has increased by only two percent when that mortgage reaches its maturity (renewal) date the additional cost, assuming the balance has not been significantly reduced, will be $7000.00 per year or $583.00 per month. That is $583.00 that must be added to the original monthly mortgage payment. Many households would not be capable of handling this increased obligation. This gives us a clear understanding of how the housing collapse occurred in the U.S. and in several European countries. Thousands of mortgages went into default and with the massive influx of homes onto the market the property values plummeted. In many cases this caused negative equity, a condition where the mortgage balance is greater than the property value. It also helps us understand why the federal finance department recently introduced a new round of changes to mortgage insurance and lending rules in an effort to rein in real estate borrowing.

In another scenario, if the mortgage had a variable rate which fluctuates according to the daily prime rate, instead of a fixed rate (locked in) over a one to five year term, the interest rate increases would have an immediate and ongoing impact on the mortgage payment, creating difficult challenges for the household budget.

Then there are the other common forms of debt held by consumers including car loans and leases, lines of credit (LOC’s) and credit cards, each with their own risks and misunderstood hazards. Car loans and leases are generally easy to obtain through dealerships utilizing the manufacturer’s financing plans. The most common hazard is that car buyers often commit to a greater amount of debt than they originally intended when offered options and upgrades with a lower than expected payment. The lower payment is made possible by an extended period of financing up to 8 years. Again, the consumer is considering the monthly payment and not the overall debt.

A LOC can involve significant amounts of debt and is also known as revolving credit with the credit limit pre-approved and the monthly payment based on a percentage of the current balance, often 2 or 3 %. The amount of approved credit on a LOC can be greatly increased by securing it with the equity in your house which may also provide a reduced interest rate. This type of credit can be a great financing and budget tool if used properly. However if misused it can contribute to major financial problems. If the credit limit is maxed out by imprudent spending, you have added to your mountain of debt. If your maxed out limit was secured by your home equity you may have even greater problems. This practice is often referred to as using your home as a piggy bank. You put money in and then take it out.

Credit cards are probably the greatest single cause of financial difficulties, for several reasons. Often known as “plastic”, they are easily available and offered by every bank and major retailer. They often carry high interest rates, from 9 % to 29 %. They make it so easy to make a purchase, often a product or service that you wanted but didn’t need. Psychologically many consumers don’t look at them as being cash, certainly not at the point of purchase. In most cases if cash was required the purchase would not have been made. It is ironic that credit counselors deal with so many clients who are overwhelmed when they receive their credit card statements, particularly after high spending holiday seasons, but yet those same clients never gave it a thought, or perhaps ignored the obvious, when they used the cards earlier. The number of credit cards with high or maxed out balances held by a consumer and the high interest rates involved, when added to the other debts as referenced earlier, often combine to create an overwhelming situation where there seems to be no way out. Such problems have been the cause of great stress, anxiety, bankruptcies and relationship breakdowns.

Some useful tips that can help you get out of debt are listed in the article How to Reduce Your Debt.

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