CIBC: Looking Beyond the Debt-to-Income Ratio

A new report by CIBC looks beyond the debt-to-income ratio of Canadians to assess how we really are doing financially.   Indeed, using simply the debt-to-income ratio to gauge the well-being of finances isn’t enough as there are some other countries with even higher debt loads that “have not experienced any grief.”

So CIBC took a look at the distribution of Canada’s household debt:

Looking at a unique data set that allows us to zoom in only on those households carrying debt, we found that all of the rise in debt since 2007 has been driven by borrowing from those with a high debt-to-gross income ratio using that measure rather than disposable income due to data limitations.

The indebted have piled on still more debt. Some 34% of households that have debt are now in the high-debt-burden category (defined as a ratio of 1.6 or above for debt to gross income) and they account for nearly three-quarters of household debt outstanding.

Not surprisingly, among those in debt, the share of those with high debt-to-income ratios is greater in provinces where housing is expensive (BC, Alberta and Ontario) as families have chased the home ownership dream in markets where price gains have outstripped incomes.

However, this is not to say that household bankruptcies are going to experience a sharp run-up since two necessary triggers are not currently present:  quickly rising interest rates and climbing unemployment.

But it does raise the spectre of a further deceleration in Canadians’ appetite and room for additional debt, as more reach the constraints of their ability to service debt. We have already seen a deceleration in consumer debt, which has sapped some of the stimulative impacts of the Bank of Canada’s low rate policy.

Housing might be next to feel the same pinch, with new construction and prices leveling off in the year ahead. That will leave Canada more at the mercy of the global environment, which remains clouded by the impacts of fiscal tightening across much of the developed world

One assumes that with rising debts, net worth and assets would rise alongside with it for the most part…

But much of the gain in total assets has been associated with rising market values for housing and land. If both mortgage debt and house price climbs are part of an unsustainable market overvaluation of housing fueled by unsustainably low mortgage rates, then the asset values could stall or even deteriorate, without a compensating change in debt outstanding.

And housing price gains do not really add to national well-being to the same extent as gains in other asset prices. As Bank of England Governor Mervyn King once pointed out, leaving aside foreign purchasers, a rise in house prices is mostly a transfer of wealth to those who own a house (i.e. the older generation) from those who will be buying one ahead. The former could sell their house and live off the proceeds, implying less need to save, but the latter have to save more to make their first house purchase.

You can read the entire report here

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