Please do not manage your personal finances like the major political parties plan to run the country.
The Conservatives, the Liberals and the NDP all have election platforms with plans to spend more than the government takes in and thereby increase the federal debt. The Conservatives say they’d balance the budget in 10 years. Today, that’s what passes for aggressive debt management.
How would your personal finances be if you took the same casual attitude toward debt? Let’s take a look using the example of a household with gross income of $200,000. That’s a lot, but let’s go with it because it’s in line with Canada’s position in the world as a wealthy country.
Even with a strong income, a family might have ideas about spending in a strategic way to improve life both now and in the future. That’s what the federal parties are talking about with their election spending plans on things such as $10-a-day child care and more money for health care.
The family in our example can’t afford to pay cash for its spending plans, but sees them as worthwhile enough to justify going into debt. For both this family and the federal parties, low interest rates make it feasible to ambitiously spend more than they take in and not worry too much about paying it back.
To put its plan into action, our family borrows $100,000 using a home equity line of credit. Borrowing money on top of an existing mortgage of average size is no problem for this family because it has lots of home equity and the bank considers it a good risk. It’s a similar story to Canada, which has a top credit rating that tells people buying its bonds that they don’t have to worry about being repaid.
Those bonds have a low interest rate of between 0.4 per cent for two years and 1.8 per cent for 30 years. Our family borrows at a higher rate of 2.95 per cent for its HELOC, but that’s historically cheap for individuals as opposed to countries. In early 2020, the rate on a HELOC might have been 4.45 per cent and a Government of Canada five-year bond would have had a yield that was two times higher than the current level around 0.8 per cent.
Low rates make it affordable for a family to borrow an amount that works out to half its annual income. In the same way, low rates make it affordable for Canada to have a federal debt-to-GDP ratio of just more than 50 per cent.
The minimum cost to our family of servicing its $100,000 debt would be $245.83 a month to cover interest only – the principal remains to be repaid at some future date. That $245.83 could have gone to savings and investments, but it seems affordable now and more so in the future if there are two working parents who get raises at work. Similarly, government debt can be manageable if the economy is growing at a good rate.
But we can’t be too complacent about higher wages – or economic growth – as we make our way through the pandemic. Despite an uptick in inflation, wages are rising only a bit faster than they were before the pandemic and the economy has been weak. The most recent report on quarterly economic performance shows a contraction, not growth.
Even so, it’s widely expected that the economy will rally once the fourth wave is done and interest rates will eventually rise. Every time the Bank of Canada increases its benchmark overnight rate, lenders will make a similar move in their prime lending rates that is passed through to the cost of borrowing on a HELOC. Meantime, the federal government will have to pay higher rates on its bonds.
Eventually, the minimum monthly interest payment on HELOCs could get too expensive for comfort for our family. At 4.45 per cent, the minimum payments rises to $370.83. Painful decisions may have to be made to afford that amount, never mind paying down the debt. Or maybe the family lets things slide for a while. Imagine a situation where one spouse loses a job and the family is financially crushed by debts taken out years ago.
A government can handle mounting debt more easily than households – it can always raise taxes or slash spending. But debt left unaddressed for a long time means tough decisions ahead, for both.
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