RBC attacks consumer debt

(March 9, 2004) North American consumers are in far better financial shape than the recent spate of doom-and-gloom debt reports would have you believe, according to a report from RBC Economics.

“The prevailing outlook on North American household finances underestimates employment, personal income and productivity growth,” said Derek Holt, assistant chief economist of RBC Economics. “While there is room for caution, too much emphasis is being placed on highly flawed measures and misled beliefs that overstate the risks to the economy.”

The report suggests the ratio of debt to income is flawed, since it compares the income of a single year to total debt, which is often made up of long-term obligations like a mortgage.

“Comparing debt to income does not take into account how debt is used,” the report said. “At present, North American households have about six times as much invested in assets compared to total debt. This suggests that the vast majority of debt is used to acquire assets such as real estate, rather than on expenses that do not provide potential returns.”

The RBC report also attacked the myth that households are “not saving enough” saying that while consumers might not save very much from their paycheques, they were building up equity in their homes, offsetting the lower rate of cash savings.

“Even though you use debt to purchase real estate, you don’t increase your net worth, because the debt itself immediately counteracts the equity in the property,” says Jonathan Sceeles, a CFP with Edward Jones in Toronto. “In title you own it, but you also own the accompanying debt that comes with it.”

If you assume that the value of the property will appreciate at a higher rate than the interest charged on the debt, the buyer’s net worth will increase over time, but Sceeles points out that studies show real estate underperforms against other investments.

“When people read these reports about financing with debt, they may make decisions based on these broad economic concepts,” Sceeles says. “Just because it’s now possible to finance a home purchase with 100% borrowed money, it doesn’t necessarily mean you should do it.”

Sceeles warns that it is likely that interest rates will begin rising in the near term and a mortgage taken out at the current low rates may become unaffordable when it comes due for renewal five years down the road. Combined with the new 100% debt purchase option, many home-buyers could find themselves forced to sell.

“I think there is a very definite danger right now that people are overextending themselves,” he says. “Are there people out there that can afford to assume more debt without getting themselves into too much trouble? Yes, there probably are, but in general terms North Americans are heavily in debt as it is. I don’t know that it’s good for most individuals to take on more debt.

“If you can manage to reasonably and conservatively make a return in excess of the cost of carrying the debt, then one can say there’s an argument in favour of investing, rather than paying down the debt rapidly,” he says. “The danger comes when your debt compared to equity is extensive and the future is uncertain as to where interest rates are going.”

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com