Calculating the optimal debt load

Our household debt is at a record high and gets higher every time Statistics Canada releases new data on debt-to-income ratios.

 From 84% in 1990 to 164.6% today — it’s an alarming leap, a dramatic number that may actually have scared some of us into doing something about our debt load.

 But is this statistic a fair measurement of our relative wealth? Is taking all debt and dividing by after-tax income (then multiplying by 100 to get a percentage) — lumping everything into one basket — the be-all and end-all of statistics?

 “Household debt is the most highly quoted indicator and probably the most misleading indicator you can think of. It’s sexy so it gets quoted,” said Benjamin Tal, deputy chief economist of CIBC World Markets. “You are comparing the stock of debt to the flow of income; it’s like you are asking people to pay off their mortgage in one year.”

 Mortgage debt is long term and a lower rate than high-interest consumer debt. Maybe we should be more worried about the cost of servicing debt, still relatively low because of low interest rates?

 Someone with a $300,000 mortgage and after-tax household income of $100,000, for example, really shouldn’t be in a full-fledged panic because they have a debt-to-income ratio of 300%. That’s a normal scenario in today’s market and not cause for alarm by itself.

 Mr. Tal says you are really comparing “apples and oranges” when you lump in long-term debt with short-term debt. “You can’t compare what you owe for 25 years to your annual income.”

He notes that housing continues to dominate our debt concerns. “All the increase in the debt-to-income ratio over the past three years is mortgages,” says Mr. Tal. And as our property values have increased at a pretty steady rate, it has been a good investment for many.

“Maybe you look at it more like the banks do in terms of debt service,” says Nadim Abdo, vice-president of consulting and analytical services at credit agency Equifax Canada Inc.

Take all your debt obligations on a monthly basis — mortgage payments or rent, credit card payments you have to make and any lines of credit you must deal with every month — and then divide by your after-tax income.

“The acceptable ratio would be between 30% and 45%,” said Mr. Abdo, adding you need the rest of that money for everyday expenses like groceries.

I don’t care who you are, but if you are paying high interest on credit card debt, that’s just stupid and you are in trouble. The bottom line is people are carrying just too much debt

Still more relevant to consider might be your debt servicing costs and then what they would be if interest rates went up two percentage points. On average, Canadian households pay about 7.6% of their after-tax income on interest payments. That number was 8.8% in 2000 and consumers were able to handle the load, says Mr. Tal.

Mr. Abdo agrees with the idea of “stress testing” yourself to see what would happen to your costs if rates start to go up.

“If you have a lot of debt, it can be significant, it can be a few hundred bucks a month for the consumer,” says Mr. Abdo. “I think the concern is what happens if interest rates go up drastically.”

The Bank of Canada is expected to keep its key rate on hold for now, giving Canadians a window to start reducing their debts before costs start to rise.

And the evidence is that consumers are paying down their debt, especially high-interest credit card debt. Equifax said in its last quarterly report that non-mortgage debt was only up 1.8% from a year earlier, noting the pace of debt accumulation was slowing. Credit card debt was down 3.6% from a year earlier.

As our debt levels have increased, our stress about debt has also increased. A study released last week by Canadian Imperial Bank of Commerce suggested debt reduction was the main priority for most in 2013, the third year it has topped the list.

Laurie Campbell, executive director of Credit Canada, agrees the household debt figure is an aggregate so it has less meaning. But, she argues, there is still something to be gleaned from the ratio.

“Don’t forget you’ve got all those people in there with no debt and that 167% was sitting at 90% a decade ago, so there is an issue,” she says. “Where is the ceiling? Where does the capacity for debt end.”

The ratio of debt to income in Canada hit 164.6.4%, Statistics Canada said in December, up from 161.7% at the end of last year. That is just a bit less than the 170% household debt to income hit by Americans at the peak of the their housing bubble in 2007.

Formulas are one thing, but Ms. Campbell says there are some other basics you might like to ask, starting with whether you have an emergency fund.

“What happens if you lose your job tomorrow,” she says. “I don’t care who you are, but if you are paying high interest on credit card debt, that’s just stupid and you are in trouble. The bottom line is people are carrying just too much debt.”

Pam Martin, Invis, Kelowna Mortgage Broker, Mortgage Broker Kelowna, Best Mortgage Rates, Okanagan Mortgage Broker, Vancouver Mortgage Broker, BC Mortgage Broker, Canada Mortgage Broker