Household debt high, but not dangerous

Reader Alert: This editorial is in response to Stephanie Holmes-Winton’s March16th column ‘What debt issue?’.

Household debt in Canada is at record levels, but the situation is not as dire as some reports have suggested.

While average household debt is $112,000, assets are also at record levels and net worth will increase as the economy recovers.

I expect household debt levels will grow more slowly in the next decade as the population ages and the labour force grows more slowly. A rising debt-to-income ratio is not necessarily a bad thing because debt can be good if it is accrued for useful purposes and if it is held by people who can afford to repay it.

In the third quarter of 2010, Canada’s household debt-to-income ratio surpassed the U.S. and reached a record high of 150%. Total debt has more than doubled in the past 10 years to $1.5 trillion.

When the U.S. hit 160%, it coincided with the financial crisis and recent recession. However, the Canadian situation is different and need not result in a similar collapse since we did not experience the same lax mortgage financing conditions and dependence on mortgage securitization or housing price bubble.

Total household debt rose by 110% in the 2000s to $1.5 trillion. But debt has grown much faster in the past—300% in the 1970s and 140% in the 1980s, before slowing to just 70% in the 1990s.

The largest part of household debt is made up by mortgages, which amount to 62% of total debt, or $942 billion, in the latest quarter. That percentage is high, but it peaked at 67% during the recession in the early 1990s. The fact the economy outgrew that problem gives us hope that it will happen again.

Central 1’s analysis shows that the fastest growing debt segment in the past decade has been personal lines of credit, which are up 455% since the end of 2000 led by home equity lines of credit.

Statistic Canada’s household debt figure includes small businesses and landlords, which inflates the numbers. Expansion in the small business sector has grown much more quickly than the household sector and also more small investors are buying condos and renting them out. But acquiring debt for investment and business purposes is a good thing for an economy.

The larger risk for households is another recession and the prospect of unemployment. As long as the economy grows, borrowers are employed, incomes expand and housing prices do not collapse, no major increase in loan arrears or defaults will occur.

Canadian household net worth is more than $6 trillion, a record high, and more than six times income, although down from 6.4 times income in 2007. Canadians have $2 trillion in equity in their homes.

The upturn in the stock market and rising house prices seen recently means the next StatsCan report will show even higher net assets for Canadian households.

The growth in household debt will slow in coming years as the population ages and boomers pay off their mortgages, though reverse mortgages are likely to become more popular.

Some people argue that house prices are overvalued. They look at price-to-income ratios which are at record highs and argue the bubble will soon burst. But they are looking at the wrong numbers.

Price-to-income ratio measures affordability, not the value of a house. In fact, house prices are also determined by supply factors, such as the availability of developable land, construction costs and government regulations, in addition to incomes.

Home prices are likely to continue to outpace incomes because of these supply issues.

By 2020 household debt is likely to rise 60% to 70% from 2010 levels, while incomes rise 50% to 55%, which will put the debt-to-income level in the range of 160% to 165%.

The latest round of mortgage insurance changes seem unnecessary if the goal was to slow the increase in debt. Growth in mortgage debt would have slowed this year and in 2012 when interest rates rise. In any case, the longer term outlook is for slower growth in debt.

If the goal is to stop the debt-to-income ratio from rising, one effective measure would be to increase the supply of housing, which would take some pressure off prices and mortgage debt.

Another important step would be to increase financial literacy so people can better understand the dangers of credit card debt and know the difference between good debt and bad.

Helmut Pastrick is chief economist with Central 1 Credit Union.