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Fig­ur­ing out if you’re tak­ing on too much debt

- Ja­son Heath Fi­nan­cial Post Ja­son Heath is a fee- only, ad­vice- only Cer­ti­fied Fi­nan­cial Plan­ner ( CFP) at Ob­jec­tive Fi­nan­cial Part­ners Inc. in Toronto. He does not sell any fi­nan­cial prod­ucts what­so­ever. Business · Mortgages · Finance · Real Estate · Money Tips · Personal Finance · Lifehacks · Julie Payette · Toronto

Fol­low­ing last week’s throne speech, it seems that fed­eral spend­ing is likely to in­crease and that means fur­ther in­creases to the fed­eral debt. Net fed­eral debt was fore­cast to ap­proach 50 per cent of GDP in fis­cal 2021 but could be closer to 60 per cent with po­ten­tial new spend­ing.

Com­bined with provin­cial debt, we could soon ex­ceed 85 per cent of GDP. In the 1990s, when in­ter­est rates were much higher, fed­eral and provin­cial debt lev­els were more than 90 per cent of GDP and led to credit rat­ing down­grades and sev­eral years of aus­ter­ity mea­sures prior to the 2008- 2009 fi­nan­cial cri­sis. Credit rat­ing agency Fitch re­cently down­graded Canada’s rat­ing from AAA to AA+ in June.

Debt is a dou­ble- edged sword. It is a com­mon and nec­es­sary tool used by gov­ern­ments and cor­po­ra­tions, but for in­di­vid­u­als, debt is a four-let­ter word that is fi­nan­cially frowned upon. So, at a time when the govern­ment is spend­ing much more than it is bring­ing in, it raises the ques­tion: how much per­sonal debt is too much?

Canada’s house­hold debt as a per­cent­age of dis­pos­able in­come has ranged from 170 to 175 per cent for the past four years, a his­toric high. It dropped dras­ti­cally in the se­cond quar­ter to 158 per cent, mark­ing the first sig­nif­i­cant de­cline in a gen­er­a­tion.

One thing that makes debt a challenge for in­di­vid­u­als is that most peo­ple will not work their whole lives to be able to cover their debt pay­ments. Gov­ern­ments and com­pa­nies can bor­row dif­fer­ently than in­di­vid­u­als be­cause gov­ern­ments and com­pa­nies do not re­tire.

Gov­ern­ments can of­ten bor­row at lower rates than con­sumers. Gov. Gen. Julie Payette ad­dressed this in the throne speech, say­ing, “Cana­di­ans should not have to take on debt that their govern­ment can bet­ter shoul­der.”

Mort­gage bor­row­ers are gen­er­ally lim­ited by gross debt ser­vice (GDS) and to­tal debt ser­vice ( TDS) ra­tios. Gross debt ser­vice is equal to prin­ci­pal and in­ter­est pay­ments plus prop­erty taxes and heat di­vided by gross an­nual in­come. This debt ra­tio can­not ex­ceed 35 per cent of in­come. TDS adds in other debt obli­ga­tions to the cal­cu­la­tion, so that to­tal debt ser­vice can­not be more than 42 per cent of in­come.

With fixed and vari­able mort­gage rates both un­der two per cent, it means bor­row­ers can qual­ify for and ser­vice higher mort­gages than ever be­fore. How­ever, since 2018, there is also a mort­gage stress test that re­quires qual­i­fi­ca­tion based on a higher in­ter­est rate as well. Right now, that rate is 4.79 per cent.

Ef­fec­tively, the govern­ment wants Cana­di­ans to stress test their bor­row­ing ca­pac­ity based on the risk of higher rates when their mort­gage comes up for re­newal.

An in­di­vid­ual or cou­ple with a to­tal in­come of $ 100,000 and a $ 25,000 down pay­ment may be able to qual­ify to buy a home for about $ 500,000 cur­rently with a five per cent down pay­ment. With a larger down pay­ment of $ 120,000 or 20 per cent, their home pur­chase price could be more like $600,000.

In many Cana­dian ci­ties, prices have risen con­sid­er­ably in re­cent years and so have bor­rower’s mort­gages. In some cases, bor­row­ers are never really re­duc­ing their debt. This may be due to mov­ing to more ex­pen­sive homes as their fam­i­lies and down pay­ments grow. Or this may be due to use of se­cured home eq­uity lines of credit that can be ac­cessed and spent as home eq­uity in­creases or as mort­gage prin­ci­pal is paid down.

Con­ven­tional fi­nan­cial plan­ning ad­vice sug­gests that you should aim to be mort­gage-free by the time you re­tire. The re­al­ity is that some of to­day’s big city bor­row­ers will never pay off their mort­gage. That may be ac­cept­able if there are both exit and con­tin­gency plans.

Some fam­i­lies may live in a large home with a large mort­gage and plan to down­size that house once they are empty nesters or upon their re­tire­ment. This may be a rea­son­able exit plan.

A con­tin­gency plan for that big mort­gage is dif­fer­ent. Last week, I took my chil­dren to the den­tist and I also got my hair cut. Who ever would have thought a year ago that both of those busi­nesses would have been shut down for a cou­ple months? It goes to show you that any­one’s job can be at risk at any time.

The risk for heav­ily in­debted bor­row­ers re­gard­less of their line of work is that due to job loss, dis­abil­ity, or even death, their debts be­come un­man­age­able for their fam­i­lies. Dis­abil­ity and death can be mit­i­gated by pur­chas­ing in­sur­ance, but job loss can only be mit­i­gated by not tak­ing on too much debt in the first place. Bor­row­ers need to have sav­ings or bor­row­ing ca­pac­ity to cover a short-term re­duc­tion in in­come or in­crease in ex­penses, es­pe­cially given how ex­pen­sive the trans­ac­tion costs can be to buy and sell a home.

A $ 1- mil­lion home pur­chase and sale in Toronto, for ex­am­ple, costs $ 32,950 in mu­nic­i­pal and provin­cial land trans­fer taxes and up to $ 56,500 in real es­tate com­mis­sions. That amounts to al­most nine per cent of the home value with­out fac­tor­ing in le­gal fees, mov­ing costs, or a mort­gage pre­pay­ment penalty.

Some bor­row­ers are bank­ing on an in­her­i­tance. Those with a sense their par­ents may leave them some­thing in their wills may no­tion­ally bor­row against that fu­ture in­her­i­tance. There are ob­vi­ously risks with this ap­proach given se­niors are liv­ing longer, the cost of long-term care is ris­ing, and there are no in­her­i­tance rules in Canada like in other coun­tries that give chil­dren a claim on their par­ent’s es­tate.

My ad­vice to bor­row­ers is to con­sider their mort­gage ap­proval from the bank as just one guide­line in set­ting bor­row­ing and home pur­chase lim­its. Per­sonal fi­nance re­quires per­son­al­iza­tion and while one bor­rower may be able to max­i­mize their debt ca­pac­ity, another may need or want lower debt pay­ments. It may be a per­sonal choice to be con­ser­va­tive, or it may be based on other ex­penses.

Some­one may have health prob­lems and an ex­pen­sive pre­scrip­tion. They may have a pen­chant for travel or goals to start a busi­ness. Maybe they want to or need to con­sider a pri­vate school for a child who is strug­gling or may re­quire spe­cial­ized as­sis­tance.

Be­fore tak­ing on debt, bor­row­ers should make sure the re­sult­ing debt pay­ments will not in­ter­fere with other short and long-term fi­nan­cial goals, in­clud­ing when in­ter­est rates rise. Pro­fes­sional fi­nan­cial plan­ners can help, but even on your own, you can eval­u­ate in­come, ex­penses, debt ser­vice, and sav­ings to try to set rea­son­able and per­son­al­ized pa­ram­e­ters.

Any bor­rower who has high-rate con­sumer debt like un­se­cured lines of credit or credit cards should re­con­sider their spend­ing and even their home own­er­ship if their high hous­ing costs are the thing caus­ing them to fall be­hind.

De­spite the fi­nan­cial in­dus­try’s en­cour­age­ment to save and in­vest, some bor­row­ers should be pay­ing down debt in­stead. Pay­ing down debt that is at higher in­ter­est rates like un­se­cured lines of credit or credit cards may be bet­ter than in­vest­ing. Avoid­ing that in­ter­est may pro­vide a higher guar­an­teed rate of re­turn than you could oth­er­wise earn on your in­vest­ments.

Savers with low tax rates that may ben­e­fit less from RRSP de­duc­tions or in­vestors with a low risk tol­er­ance may also be bet­ter off re­pay­ing debt over in­vest­ing.

De­spite low in­ter­est rates, all bor­row­ers — whether first-time home­buy­ers or fed­eral gov­ern­ments — need to plan for higher in­ter­est costs in the fu­ture. Debts that may be man­age­able now may be­come less so when bor­row­ing costs in­crease. Ris­ing fi­nanc­ing costs could im­pact every­one’s abil­ity to spend on other things at some point down the road.

The risk of higher rates in the fu­ture is one thing that is lead­ing to op­po­si­tion to fed­eral and provin­cial govern­ment bor­row­ing to­day. That same risk, among oth­ers, is another rea­son to bor­row strate­gi­cally to avoid tak­ing on too much debt your­self.

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