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The shift in Canadian’s debt-to-income ratio has been driven by more low-income people taking on large mortgages.Fred Lum/The Globe and Mail

Soaring levels of mortgage debt have left one in 10 Canadian homeowners vulnerable to an economic shock. But with much of the risk concentrated among a small group of borrowers, policy makers are in a difficult spot of having to cool an increasingly niche segment of the housing market.

Canada's household-debt-to-income ratio neared a record 165 per cent in the second quarter. Total household debt has increased since then, rising at an annualized 5 per cent in October, the fastest pace of growth in more than three years, Royal Bank of Canada reported.

But in a new study for the C.D. Howe Institute, economist Paul Jacobson and former Toronto-Dominion Bank chief economist Craig Alexander argue that most Canadians have handled their debts responsibly and that much of the risk from rising household debt comes from the core group of homeowners whose debts have soared in the wake of rising home prices and falling interest rates. "I don't think the data naturally argue that the bulk of Canadians are in trouble," Mr. Alexander said in an interview. "What it's telling you is that there's a segment that are taking significant risk."

Debt rose across all ages and income levels between 1999 and 2012, the economists found, but has risen the most among those at the bottom of the income ladder, the youngest homeowners and those in the most expensive housing markets.

Since 1999, the share of Canadian homeowners who have mortgage debts worth 500 per cent of their after-tax income jumped from little more than 3 per cent to nearly 11 per cent. An equal proportion of homeowners report having fewer than $1,500 in liquid financial assets that could be used to pay bills in a crunch.

The largest jump in deeply indebted households was in British Columbia, where skyrocketing home prices helped push up the average mortgage debt to 375 per cent of after-tax income and the share of households with debts worth 500 per cent of their income has nearly doubled to 20 per cent. Ontario has seen a similar rise in debt, with the average debt-to-income ratio rising to 350 per cent in 2012.

The shift was driven by more low-income Canadians taking on large mortgages. The share of Canadians in the lowest income bracket who had mortgages of more than $300,000 jumped nearly 11 per cent since 1999, compared to an increase of about 7 per cent among middle-income earners. Much of that increase came from Canadians under the age of 35, which Mr. Alexander suspects is likely first-time buyers in expensive cities such as Toronto stretching their ability to pay to get into the market. "There are a lot of young people who feel that if they don't get in now, they won't be able to afford it down the road," he said. "It's contributing to the burden of debt we're seeing in the economy and you worry about the amount of leverage they take on."

Federal regulators have steadily tightened lending standards and mortgage insurance rules in the wake of the global financial crisis, leaving Ottawa with few options to curb the pockets of risk that still exist in the housing market.

Mr. Alexander argues that regulators should look at policies such as raising the minimum down payment for mortgage insurance over a certain price point that would target expensive markets such as Toronto and Vancouver, or consider requiring lenders to test borrowers' incomes against interest rates two percentage points higher than the banks' posted mortgage rates to prepare homeowners for rising interest rates in the future. Ottawa could also follow the lead of the Bank of England, which last year restricted the number of mortgages lenders could make for more than 450 per cent of a borrower's income.

He likens the choices faced by Canada's new Liberal federal government to a car driving on the highway and hitting a patch of ice. "If you slam on the brakes, you actually cause the thing you fear and you likely end up having an accident," he says. "The first thing you do is you stop pushing on the gas pedal. The second thing you do is very gently tap the brakes. Gently leaning against the tendency to take on large amounts of debt is probably a healthy thing to do."

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