Canadians’ household debt is high, but risk of major shock is low: economists

Decades of low interest rates and strong housing demand have led to high levels of household debt for Canadians, and now rising interest rates are increasing the cost of servicing that debt.

But economists say that just how much risk that debt poses depends on whether the central bank is able to slow inflation without causing a major economic shock.

“If there is no economic shock of a very large magnitude, then it is quite possible that Canadians will be able to afford this higher (debt) servicing,” said TD economist Maria Solovieva.

Statistics Canada recently reported that Canadians owed $1.85 for every dollar of disposable income in the first quarter of 2023 as higher interest rates make their way through an economy already grappling with inflation. And Canada has the highest level of household debt in the G7, according to the Canadian Mortgage and Housing Corp., with mortgages making up around three-quarters of that debt.

But Canada’s high debt levels aren’t a new phenomenon. What we owe relative to income has been increasing for decades, RBC assistant chief economist Nathan Janzen said.

Strong population growth has added to demand for housing, helping boost prices in a market where debt has been cheap for homebuyers, Janzen said.

As the economy ramped up in the wake of pandemic reopenings, the annual inflation rate passed 4% mid-2021 and peaked at 8.1% in June 2022.

In a bid to quell inflation, the Bank of Canada raised its key interest rate, which it had slashed to almost nothing in the onset of the pandemic. Its overnight rate target went from 0.25% at the beginning of 2022 to where it stands now at 4.75%.

The rate hikes by the central bank have in turn driven the prime rates charged by the big banks higher and helped push the cost of other loans up.

“As those debt payments rise, that soaks up an increasing share of household after-tax incomes and leaves less to spend on everything else,” Janzen said. “It’s kind of part of the plan from the Bank of Canada’s perspective to kind of soak up purchasing power and allow demand … to slow to a point where inflation pressures get back under control.”

However, because interest rates take time to work their way through the economy, the Bank of Canada is playing “a little bit of a guessing game,” Janzen said. The cracks are beginning to show for some households, he said, but the central bank’s rate hikes have yet to make their full impact known.

“There’s a pretty wide distribution of debt levels and income levels and savings levels,” he said, which means the effects of higher interest rates will not be evenly felt.

Statistics Canada reported earlier this month that the household debt service ratio, measured as total obligated payments of principal and interest on credit market debt as a proportion of household disposable income, was 14.90% in the first quarter of 2023, up from 14.40% in the fourth quarter of 2022.

David Macdonald, senior economist at the Canadian Centre for Policy Alternatives, said for homeowners with fixed-rate mortgages, the effect will be delayed until they have to renew their loan. Meanwhile, would-be homebuyers are feeling the pinch today, resulting in a slowdown of new mortgages.

But it’s not a perfect science. Because home prices aren’t falling enough to offset interest rate hikes, the higher cost of housing overall can actually contribute to inflation, said Macdonald. And while higher rates are weighing on some areas of the economy, they’re also contributing to lower new home construction amid a housing crisis, he added.

“The idea that we’re fine-tuning something in the economy with a two-year delay seems almost laughable,” Macdonald said.

The central bank is trying to avoid an “1980s-style downturn,” said Janzen, referring to a period when dramatic interest rate hikes took a big toll on the economy.

RBC currently expects a mild downturn, said Janzen, noting that Canada’s financial system is strong and healthy. And while more Canadians will fall behind on debt payments, a recent report from RBC said most households will manage.

TD’s Solovieva said the labour market so far is proving to be resilient and that she thinks the country can avoid any major shocks.

“That’s not to say that some Canadians won’t feel the pain,” she said.

Over time, Canadians will adjust their behaviours and in many cases extend the duration of their debts, weighing on consumption and growth over the longer term, Solovieva said: “This is going to be a gradual process.”

Macdonald said he doesn’t expect to see huge spikes in defaults or bankruptcies the likes of which were seen during the financial crisis, but added that “we should be reasonably worried.”

“The larger problem isn’t so much that everyone goes bankrupt, the larger problem is that everyone’s paying so much in interest, they don’t spend money on anything else, and you see a big impact on economic growth,” he said.

“That’s, to my mind, the real danger.”