A major issue arising in Canada hasn’t received too much attention lately. Year after year, quarter after quarter, the level of the household debt is increasing both in absolute and relative numbers:
The net debt versus disposable income tells you the total amount of debt in a household versus that household income and is a bit comparable to a net debt/EBITDA ratio on a company basis. A ratio of 170% means a Canadian household would have to spend 21 months of its (entire!) disposable income on debt repayment before being debt free. If a repayment capability is for instance just 20% of the disposable income, you’re talking about a repayment period of 10 years – excluding the additional interest expenses.
Did you want to see another perspective? The next chart shows the net debt versus Canada’s GDP. As you can see, this ratio has increased sharply, indicating Canadians are outspending.
And finally, a third chart which should worry you; the total amount of car loans.
One of the ‘arguments’ from those who consider the elevated debt levels ‘not too bad’ is the argument the asset value of the households is increasing as well, predominantly due to increasing real estate prices. Technically, one is correct when assuming the increasing asset prices keep the debt/equity ratio in balance despite an increasing debt level.
However, the real estate market is actually a major part of the problem in Canada, and that’s also something the Bank of Canada has pointed out in a recent update. The total indebtedness of the Canadian households actually increased exactly due to the increasing real estate prices, increasing the need for its citizens to apply for larger mortgages.
Canadians seem to think the only way the real estate prices are going, is up. Does this sound familiar to you? Because it definitely sounds familiar to us, as inflated real estate prices and ‘over-borrowing’ homeowners were the main culprits of the global financial crisis in the USA in 2008.
Back then, the Canadian banks were seen as some of the safest banks in the world, but the stability of the main banks is now being threatened by losses related to loans to oil companies and a negative shock in the real estate market might have very negative consequences. Even if we wouldn’t expect the housing prices to drop but to level off, the expected increases in the benchmark interest rates will make a mortgage much more expensive.
Whereas the average cost of a mortgage is currently approximately 3%, this could easily increase towards the 5% level by the end of the current decade. If you’re a Vancouver- or Toronto-based homeowner who borrowed $1M, your interest expenses will increase by $20,000 per year or $1,500 per month. That’s a pure cost increase and doesn’t reduce the principal payments on your loan.
According to the Bank of Canada, the total amount of mortgage debt increased by 6% in the past year to C$1.45T. A 2% increase in the average cost of debt would increase the total annual payment by C$30B. To put this in perspective (as the C$30B will have to be funded by slashing other expenses), that’s approximately 2% of the country’s GDP so you can be pretty certain the trickle down effect will be substantial.
Source: Bank of Canada
And the higher mortgage rates will have another negative consequence. Exactly because the cost of debt is increasing, fewer people will be able to afford a mortgage, and banks will tighten their conditions. This by itself will cause the real estate prices to stall, and very likely to decrease. After all, unless the foreign buyers are filling the gap, there will be fewer buyers in the market for the available properties. The central bank is absolutely right when it says the ‘household vulnerabilities have moved higher’.
A low oil price, low (hard) commodity prices, an ‘over-borrowing’ population and an overvalued real estate market. Oh, what could possibly go wrong?