This is part of a Globe series that explores our growing dependence on credit – from the average household to massive institutions – and the looming risks for a nation addicted to cheap money. Join the conversation on Twitter with the hashtag #DebtBinge
Household debt is at an all-time high in Canada. David Parkinson, Barrie McKenna, Jacqueline Nelson, Tavia Grant and Tamsin McMahon explore the challenges ahead, potential solutions – and how one country has kept its consumer debt levels in check
The central bank
The obvious way to discourage Canadians from piling on more debt is for the Bank of Canada to start ratcheting up interest rates, and soon.
It's a straightforward and time-proven equation: When borrowing costs more, people borrow less. Yet the reality is more complicated. Crank up rates too fast and overstretched borrowers could struggle with the higher loan payments that go along with increased rates.
Anyone who has borrowed on a variable rate of interest that moves up and down whenever official rates change – which includes many mortgages, as well as lines of credit – will feel the pinch. An increase in interest rates could put the most at-risk debtors in serious trouble. And more generally, it would also constrain consumer spending, as households turn their attention to their increased borrowing costs.
The key, said former Bank of Canada governor David Dodge, is a slow and steady return to more normal rates.
"It's true that in running up rates quickly, some households would get caught off-side and they are going to have problems," said Mr. Dodge, who ran the central bank from 2001 to 2008. "There will be a period … when there will be reduced consumption as households adjust to higher carrying costs of debt that they've taken on.
"This adjustment period is going to be very tricky because [by having low rates and high levels of borrowing] we've brought forward a fair bit of consumption in time, and there will be a gap as households adjust to higher interest rates. So it's better if those rates moved up relatively slowly and gave households time to adjust in a smoother manner."
Mr. Dodge said higher rates would effectively take higher-risk borrowers out of the mortgage market – something the government has been trying to do through progressively tighter regulations governing mortgage lending. "It's a market way of getting there, rather than trying to control the market by putting on ever-tighter restrictions on mortgage insurance, supervision of bank mortgage and auto lending," he said.
But Benjamin Tal, deputy chief economist at CIBC World Markets, cautioned that even small rate increases could have a bigger-than-usual impact this time around. "It's because of the size of the exposure, and the fact that rates are so low," he said, noting that even if you raised the rate on a loan from a very low 2 per cent to a still relatively low 3 per cent, that represents a 50-per-cent rise in the borrowing cost. "It's such a huge increase, in terms of interest payments and ability to pay."
However, he said, this increased sensitivity to rate increases should itself moderate the pace of rate normalization. Typically, the Bank of Canada raises interest rates to cool a hot economy and keep inflationary pressures in check; if even a small rate increase applies significant brakes to economic growth, the central bank will see less need for additional increases in the near term.
"The disease is also the cure," he said. But the Bank of Canada believes that before we start raising interest rates, we first need a healthier economy. That would generate income growth to give Canadians better means to pay back their debts, and a better cushion to absorb higher costs when rates do eventually go up.
That means keeping rates low while the economy is still operating well under its capacity, as it is today, in order to stimulate growth and employment and put upward pressure on wages. "We believe that the best contribution the bank can make to lowering financial stability risks through time is to help the economy return to full capacity and stable inflation sooner, rather than later," Bank of Canada Governor Stephen Poloz said in a recent address.
Barrie McKenna and David Parkinson
The federal government is betting that when it comes to improving Canadians' financial strength, knowledge is power.
Whether its digging out of debt, fighting fraud or teaching the next generation how to manage their money, the Financial Consumer Agency of Canada is seeking advice on how to help groups such as seniors, newcomers to Canada and youth make sound financial decisions and plan for their future. The government group is developing a national strategy for financial literacy set to be revealed later in 2015, with the goal to strengthen the national economy.
"Very complex financial products are out there for all age groups – for [youth], for adults and for seniors. It's very important to help guide people through these complicated products," said Jane Rooney, Canada's first financial literacy leader, who was appointed last year.
Ms. Rooney is bringing public, private and not-for-profit sectors together to weigh in on how to improve Canadians' understanding of core money concepts and is nearly one year into an extensive consultation period. She not only wants to zero in on the most important messages, but also aims to prevent conflicting information from confusing Canadians.
In the short term, Ms. Rooney would like to see more Canadians taking advantage of the online financial resource database the government has rolled out, which is loaded with more than 860 different tools and worksheets on topics such as fraud, mortgages, loans and financial planning.
But getting people engaged is poised to be a significant challenge.
"I think we can achieve some basic level of understanding, like basic debt, savings and credit card issues," said Greg Pollock, chief executive officer of Advocis, the financial advisers association of Canada. But many people "are much more interested in having a root canal done than delving into their finances and figuring out if they're going to have enough money in retirement." Some of that responsibility should fall to financial planners, he said.
But the best way to spur change may be by reaching out to the next generation.
"One of the most important areas we see to address [desensitization to debt] is kids," said Gary Rabbior, president of the Canadian Foundation for Economic Education. "People obviously care about kids. Sometimes they'll smoke, but they won't want their kids to smoke. You may drive too fast, but you don't want your kids to drive too fast."
Ms. Rooney points out that when kids are educated, it can improve parents' financial responsibility, too.
"Reaching children and youth with key information is so important because then they can bring that into their home," she said.
It will take years – perhaps decades – to see results. "We're at the very start of a campaign to make widespread changes," Ms. Rooney said. "We're talking about the workplace, in the financial services sector, the school system – so through common goals and messaging we'll have impacts, but it will take a long time to see significant changes."
Nearly two million Canadians a year take out a payday loan.
Regulating the sector is a delicate balancing act. The growth since the 1990s demonstrates the demand for short-term, small-sum loans – and that demand won't suddenly vanish if the industry goes away.
Crack down too hard without adding any alternative services and these lenders could disappear, forcing some consumers to turn to unlicensed, unregulated online lenders, or underground means, which could see desperate people paying even higher rates. Do nothing, and some of the most vulnerable parts of the population will continue to get into trouble.
But some proposed recommendations are reasonable and, crucially, wouldn't kill the industry. Collecting more data – as is already being done in British Columbia – would give a clearer picture of growth rates in the sector and reveal whether people are borrowing more. A better grasp is also needed of a newer segment – unlicensed online payday lenders.
Another suggestion is to ensure all provinces require annual percentage rates (APR) be clearly posted, so people understand that payday loans are a pricier way to borrow.
In Ontario, for example, where the APR is not required to be posted, a $21 rate for every $100 advanced might sound like it's a 21-per-cent rate on a yearly basis. It's not.
The interest works out to a 546-per-cent annual rate. The industry objects, saying this is misleading because these loans are only offered on a short-term basis. But critics argue disclosure of this rate is the norm for other loan products, such as credit card interest and mortgages.
As Calgary's Momentum notes, "the ability to educate oneself about financial options and compare is a basic tenet of financial literacy."
Recommendations on how to tighten the rules abound – and many ideas are being tested in U.S. states such as New Mexico or Colorado, such as lowering the caps on fees or limiting the size of a loan to a percentage of the person's income. They'd be worth studying.
A problem is that regulation has been left up to the provinces. The result is a patchwork of widely differing rules. In the U.S. and Britain, the federal consumer watchdogs are taking a lead in tightening rules. In Canada, the Financial Consumer Agency of Canada notes that this is a provincial matter (and wouldn't provide anyone for an interview, despite requests).
Nonetheless, this agency could arguably play a greater role in scrutinizing the impact this sector is having on consumer finances.
Then there are the banks and credit unions, some of which have run pilot projects, or are now dabbling in how to provide lower-cost alternatives. They have the expertise. And they are bound by access to basic banking rules – the spirit of which says all Canadians should have access to affordable services.
A reluctance to enter this market has prompted some criticism that we are headed toward a two-tier banking system, where the poor and most in need seem to be paying the highest fees.
A different approach
Canada isn't alone in its struggle to curb rising consumer debt. Globally, household debt hit $40-trillion at the end of last year, 10-per-cent higher than before the 2008 financial crisis, a recent study by the McKinsey Global Institute found.
One Western country that has managed to keep household debt in check is Germany. Germany's housing market has been remarkably stable for decades.
By the end of last year, German household debt stood at 54 per cent of gross domestic product, compared with 95 per cent in Canada, the McKinsey study found. Despite emerging as Europe's strongest economy in the midst of a sovereign debt crisis, German households managed to lower their collective debts by 6 per cent between 2007 and 2014. During the same time, Canadian household debt increased by 15 per cent.
Part of the difference is cultural. Less than a third of Germans own a credit card and more than half of purchases are made using cash, a 2012 study from central bank Bundesbank found.
Much of the difference stems from Germans' attitude toward housing. Government tax incentives skew in favour of renters. Thanks to a well-developed rental market, just 53 per cent of Germans are homeowners – compared with 69 per cent in Canada.
German buyers overwhelmingly take fixed-rate mortgages, most of them for terms greater than 10 years, Michael Voigtlaender, a professor of real estate at the Cologne Institute of Economic Research, wrote in a 2012 study on the stability of the German housing market. Less than 1 per cent of German mortgages have floating interest rates, compared with about a third of Canadian mortgages.
As a result, Germans had far less mortgage debt. In 2010, total outstanding mortgage debt in Germany was equal to 46.5 per cent of GDP compared with 59.5 per cent in Canada.
But the critical difference comes down to the mortgage lending practices by German banks. In Canada, as in many other countries, lenders typically appraise homes based on their market value. In Germany, most lenders use something called beleihungswert or "mortgage lending value."
By law, German appraisers have to ignore what's happening in the market and instead calculate a long-term, sustainable value of a property, the equivalent of what the home would sell for in the midst of a crash. Banks use the figure to calculate how much they will lend to a borrower.
In practice, the mortgage lending value typically works out to about 80 per cent of the actual purchase price, meaning banks will require borrowers to pay a down payment of at least 20 per cent. But that gap will fluctuate depending on whether the housing market is hot or cold. When prices are booming, the gap between the mortgage lending value and the market value will grow, requiring borrowers to fork over larger down payments. At times, the mortgage lending value has been as much as 40 per cent below market value, the Association of German Pfandbrief Banks said.
When the market is cooling, the gap will shrink and so will the required down payment. In essence, the process means that Germany's mortgage market runs countercyclical to the housing market, making it harder for buyers in boom times and easier for them when the market goes soft.