FP COMMENT: CANADA’S DEBT FICTION,

In Statistics Canada’s most recent quarterly update for the household balance sheet, data show Canadians have personal debts of 165 per cent of their disposable income. So, for every $ 100 they take home after all taxes and transfers, they owe $ 165. That 1.65 ratio, which is now the highest it has ever been, marches upwards quarter by quarter, each time prompting public commentators to agonize about the increasing debt load of Canadian households.

But Statistics Canada also releases another ( less frequent) study called the Survey of Financial Security ( SFS), which provides a much more granular picture of household debt levels. The last survey was released over 18 months ago. It reveals a much more nuanced story. With the benefit of having rummaged through the SFS data set for the last few months, I would say that there are several misconceptions that can arise from paying attention only to the headline household debt number of 1.65 and ignoring the fine print.

Average debt levels are not like our legs. The average number of legs a Canadian has is two. The variation is (virtually) zero. Not so with debt. The debt load of 165 per cent is an average across a large segment of the population at different ages, living in a variety of housing arrangements in various regions. As you can see in the accompanying chart, 40 year olds have much more debt than do 80 year olds, on average. A 165 per cent load is low and quite normal for a 40 year old, but highly abnormal for an 80 year old.

All debts are not equal. If you owe $100 on your mortgage at an interest rate of 2.5 per cent amortized over the next 10 years, most financial advisers would consider that relatively good debt. But if you owe $ 100 on a credit card at 20 per cent interest, that is really bad debt. Yet, these two types of debt — and everything in between — are lumped together in the officially reported 165 per cent debt load.

The debt- load will not necessarily get worse when interest rates rise. It’s true, if the Bank of Canada eventually hikes rates, your credit line will charge more and renewing your mortgage will mean higher payments. But the ratio of debt to disposable income does not capture current interest rates. It’s what we owe relative to what we earn. Earnings could rise just as fast, or faster, than interest rates.

A housing correction will not necessarily change the debt ratio, either. Housing prices could plummet tomorrow, but your mortgage owing would remain the same. What could happen, is a second-order effect, where the economy goes into a recession and you lose income. Your debt level would stay the same, but your income could decline, which would eventually cause debt- to- income ratios to rise. But these effects don’t follow immediately.

There is no rule that a lower debt ratio is better. Debt is a necessity in a modern economy, especially for younger people and businesses, but its many effects are subtle. A fundamental axiom in accounting stipulates that net worth on your personal balance sheet should not change when you borrow: an additional dollar of liabilities ( say, in a mortgage) used to finance the purchase of an additional dollar of assets ( like a house) results in the same level of equity. Moreover, if the additional debt is consumed — i. e., spent or squandered — the same axiom dictates that equity ( or net worth) should decline.But in reality, our major assets more often increase in value over time by more than the debt we use to finance them. In fact, the SFS data show that households with an additional dollar of debt on their personal balance sheet, relative to identical Canadians who do not have the extra dollar of liabilities, actually have an additional 0.35 cents of equity. So, $100 in additional debt is associated with an additional $3.50 of net worth. ( You can’t chalk this all up to increasing real estate prices: the effect is even more pronounced for renters than homeowners). Looking at the chart, notice that households with debts over $200,000 have a median net worth of $377,000; those with debts over $ 600,000 have a median net worth $1,172,000. So, which would you rather be?

Just because a bank is willing to lend you money is no reason to be complacent. Most people care less about economy- wide surveys and more their own debt. Their main concern is: “Will the bank lend me the money to buy my dream house?” Banks don’t use the national 1.65 number; they care about interest payments relative to your pre- tax income. Their Debt Service Ratio ( DSR) number is very different from the debt- to- income ratio. Looking at the SFS data again, the “true” debt-service ratios are quite scary for older households. I estimate that 10 per cent of Canadians over 65 will be spending over 50 per cent of their disposable income to pay off debts during their remaining lifespan.

The bottom line is this: As the average Canadian debt load of 165 per cent approaches the average Canadian’s weight load of 185 lbs., remember that it’s the number on your own scale that matters most of all.