I remember landing in the UK 3 years ago and sitting down with a banker to discuss UK finances. Somehow, we found ourselves on the topic of mortgages and I was quite alarmed to learn that you can get a mortgage which has interest only payments. There was no requirement to pay down the principal, essentially leaving the borrower in debt forever.
That mindset has been leaking into the Canadian economy over the last decade as household debt has sky rocketed. TD Bank raised the alarm bell recently:
Canadians are carrying far too much debt relative to what they earn, and the problem is only going to get worse if the Bank of Canada maintains a low-interest rate environment over the next few years, a report from TD Economics warned yesterday.
Craig Alexander, chief economist with TD Bank, said household debt as a share of personal disposable income has tripled since the 1980s, to 146 per cent from 50 per cent, with debt accumulation accelerating at an alarming rate especially since 2007.
That figure could rise to as much as 151 per cent by 2013 if the economy grows at a moderate pace and the Bank of Canada only raises rates to 3.5 per cent by that time.
The reasons why? Two income families provides a sense of income security (only 1 will lose a job), stable job market, low inflation and low interest rates. But as interest rates rise (they must, it is inevitable), those with a high debt rate will find it harder and harder to sustain. As TD points out:
As well, the most vulnerable households are those at the lower-end, with low-income families holding the highest debt-to-income ratio (180 per cent) and highest debt-service ratio (25 per cent).
"Low-income families are more susceptible to adverse economic shocks, more likely to lose their jobs, and they do not have a strong asset base that they can liquidate in times of financial stress," he said.
In other words, the poor will suffer. Spain is a great example of what can happen. The Globe ran a story on how Spain’s poor are suffering through the crisis as unemployment rises, housing prices collapse and the debt from homes they cannot afford crush the low income earners. Low income earners who have made some tragic mistakes:
In 2006, a Barcelona bank offered him a “free” mortgage – with no down payment – that was offered, signed and closed in one day. His salary of €1,100 a month was combined with his wife’s earnings of €600, and the bank asked them to claim they worked weekends (they didn’t) in order to make their income appear high enough to qualify them.
Before he had a chance to think about it, Mr. Cadena was given the keys to the apartment and a 2-centimetre-thick package of fine-print pages he either couldn’t or didn’t read, and was told the mortgage payments would be €900 a month, withdrawn from his account.
He had no idea how much he’d paid for the 3-bedroom basement apartment (only this year did he realize it was an extraordinary €253,000) or the interest rate (5 per cent above prime).
The monthly payments, he soon learned, were calibrated to rise over time, first to €1,100 euros and then, in 2009, to €1,600 – a mortgage structure, also popular in the United States, that only made sense under the assumption both the borrower’s income and the house’s value would rise quickly and constantly.
They didn’t. The collapse of Spain’s property bubble coincided with the rising mortgage rates faced by Mr. Cadena (and many others). In early 2009, his construction company cut his shifts to six hours per day; in November they folded completely.
This man is left losing the house and still owing €200K (they do not have a bankruptcy option). Money that he does not have, in a job class that makes it almost impossible for him to ever repay it.