While many economies around the world are staggering under huge public and private debt burdens, Canadians are likely feeling sanguine. Our governments' net debt burdens remain well below international norms, and we have not experienced anything like the housing meltdown in the United States, which has put more than one-third of that country's mortgages “under water” – a scenario in which the amount owed exceeds the market value of a home.
Still, rapidly rising household debt amounts to a “Canadian debt bomb” that has been ticking more loudly. Canadians will have to slow their debt accumulation or it will explode. Moreover, many Canadians will need to save more to achieve their desired standard of living in retirement.
Much of the alarm about the indebtedness of Canadian households focuses on the sector's debt being 146 per cent of personal disposable income. This is up from 90 per cent just 20 years ago. And two decades before that, indebtedness was less than 80 per cent of after-tax income. This rise in household indebtedness is a sociological as well as economic and financial phenomenon.
Each generation seems to move further away from the notion of saving before making major purchases. The culture has shifted to borrowing so that the purchase can be made immediately. Financial innovations, such as home-equity lines of credit, have facilitated the shift.
A trend rise in household indebtedness is not necessarily troubling. Much of this debt is long-term, so it does not need to be paid out of just one year's income. In good part, the debt was acquired to build assets, principally in housing but also in equity markets. With strong asset rates of return until the Great Recession struck, net household worth had been rising despite the growing debt. And with record low interest rates, the cost of carrying that debt is low.
The soundness of the Canadian financial industry provides some security not found in other countries. Most Canadian institutions have strict conditions for lending and are well capitalized to cover any defaults. Mortgages with less than 20-per-cent equity must be insured.
The overall trend toward greater household indebtedness may not be very troubling, but the recent acceleration is. For many years, debt was rising about 2.5 percentage points faster per year than income. The gap had widened to 4 to 5 percentage points by 2005 and blew even wider during the recession. Despite a softening in incomes, housing returned to its boom after a brief pullback as Canadians embraced the allure of low interest rates.
Some telltale signs of stress are already appearing. In 2008, the value of household assets experienced its first decline, falling 2.7 per cent. On the other hand, liability growth continued, unabated by the Great Recession, rising by 9 per cent in that same year. And while assets recovered somewhat in 2009, the asset-to-liability ratio hit an all-time low as liabilities again grew faster than assets. The Bank of Canada estimates that, despite the record low interest rates, debt servicing charges put 6 per cent of Canadian households in a vulnerable financial position.
That will surely rise as interest rates inevitably rise. TD Economics expects short-term interest rates to rise to around 4 per cent and longer-term government bond rates to be closer to 5 per cent within the next few years. That will push the portion of household income going to interest charges to a 20-year high.
