Debt and the Canadian Real Estate Bubble

I’m not opposed to owning a home. I think owning a home is part of the Canadian and American dreams. It provides emotional security for you and your family, and can also in some cases provide some financial security. It even acts as a method of forced savings because you have to make mortgage payments every month. Owning a home can be a key to financial freedom.

With that said though, I don’t advocate buying a home at all costs. I feel like that’s what’s happening in Vancouver, Victoria, Toronto and now Toronto’s suburbs. Canadians in these places are stretching themselves to get into the housing market. Some are taking on all the debt a lender will allow them to take on. Alternative lenders are becoming popular as some of the big banks are clamping down on mortgage lending. Mortgage fraud is also on the rise with some applicants saying they fudged numbers on their mortgage applications and potential applicants saying it’s okay to do so.

So the way house prices are in Vancouver and Toronto right now, I think there is one huge systemic risk to households: Debt.

Don’t take my word for it. Look at the chart below. Take a look at the overall expansion of household debt. Total debt now exceeds Canadian GDP – a precarious position. Most of it is in mortgages.

canadahouseholddebt

I find the next chart interesting. Take a look at median after-tax income below, it has barely increased. So then what’s driving up house prices, debt of course. Canadian debt and home prices have increased in near lock step with most of this debt being taken on in Vancouver and Toronto – all the while household incomes remain stagnant.

hilliard-macbeth-chart

So what are the risks to you associated with borrowing too much?

  1. Well, one is increasing mortgage rates. People always refer to the Bank of Canada not raising their rate for the foreseeable future. This may be true but mortgage rates are set by bond yields which are already increasing and some of the big banks have already started to increase their rates. If Donald Trump is able to push through significant US corporate tax cuts and infrastructure spending, you would expect inflation in the US which should result in the US Fed increasing interest rates. Either the Bank of Canada follows or the Canadian dollar gets killed. So higher interest rates should be on the horizon. This would squeeze households’ finances as mortgage payments increase.
  1. The other is job loss. Canada’s economy has been moving towards part-time and self-employment work. Full-time job growth hasn’t been significant over the last few years. Many indebted Canadians are living paycheck to paycheck so a job loss could put many of these people on the brink. They may have to pay off debt with debt – a vicious cycle that some people never get out of.
  1. Debt can also be emotionally and mentally crippling. One of the biggest reasons relationships break down is because of financial stress.

I try to consider these risks when borrowing. I think there are only two kinds of “good” debt – 1) mortgage debt; and 2) debt used to start a business or invest. However, I only borrow if I’m extremely certain that I’ll be able to keep paying it off if I’m out of work (e.g., out of work for six months or a year) or if interest rates rise substantially.

There’s no one set borrowing threshold for everyone. Each household has different incomes, expenses, and priorities. The important thing is to manage your household debt.

A tool that I use to calculate how much “house” I can buy is the Real Life Interactive Spreadsheet created by Rob Carrick.

The great thing about this tool is that it accounts for all of your other costs in addition to your mortgage. Too often, people just focus on their mortgage payment. But we have to remember that there are so many other costs associated with our lives. After completing the spreadsheet, it tells you what your Real Life Ratio is – whether or not you can afford that house.

If you can afford that mortgage, and afford to put something aside for retirement and pay your everyday expenses then buying that home is definitely is a plausible option. But if not, it’s not the end of the world. There are other options: Buy something cheaper, rent, move to the suburbs, or move to a different city. You don’t want to be over-leveraged in any situation, let alone in an economy that is over-leveraged.

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