Over the past 25 years, Canadians’ household debt has increased steadily as a share of their disposable income. During this time, and especially since the financial crisis, they have often been told their debt levels were unsustainable and that a day of reckoning was fast approaching. And yet that day has not come. One reason why seems clear: for the most part over the past 25 years, the amount Canadians spend servicing their debt has not changed as a percentage of their disposable income.
In a recent C.D. Howe Commentary, we argue that it is primarily this “debt service ratio” (interest payments plus reimbursement of principal divided by disposable income) that determines households’ ability to make their payments at the end of the month. If this ratio spikes, that should be a red flag regarding financial instability. But for most of the past 25 years, other than the lead-up to the 2008 financial crisis and a much smaller uptick now, it hasn’t, unlike more traditional and — we argue — less important credit measures.
For instance, one of the most widely reported debt figures is the ratio of total household debt (mainly mortgages, car loans, and student and credit card debt) to disposable income. It sat at a whopping 176 per cent at the end of the third quarter of last year, compared to a little over 85 per cent at the beginning of the 1990s.
But what people owe is only one side of the coin. The other side is what they own and Canadians’ net worth has never been higher. Heading into the final quarter of last year it was equivalent to 870 per cent of disposable income, almost five times their debt ratio.
Neither of these two results is all that surprising. You would expect to see a higher debt ratio in an environment where interest rates have declined. The 10-year Canadian government bond yield was 9.75 per cent in January 1990, 6.49 per cent in January 2000, 3.48 per cent in January 2010, and just 1.60 per cent in December 2019. Declining interest rates have been a worldwide phenomenon, explained by falling birthrates, aging populations and a slowdown in real growth.
As interest rates have fallen, cheaper borrowing has led to higher asset prices, most notably for houses. Higher house prices have in turn led to people taking on bigger mortgages. But the interest they pay on their mortgage has fallen as interest rates have fallen. As a result, and not surprisingly, the debt service ratio has remained mostly flat in Canada over the past quarter century, even as the debt ratio has risen. Households typically borrow when they are young and pay back their debt over time. Lower interest rates will — perfectly rationally — lead them to spend more on housing and also to substitute present consumption for future consumption, which means borrowing more. The optimal debt ratio will rise as interest rates fall and fall as interest rates rise (if interest rates ever do rise again). That the debt service ratio has been so flat for so long suggests Canadian households have been carrying as much debt as they think they can handle, given both their incomes and the low interest rates we have had since 2008.
Our results suggest regulators and policy-makers should put less weight on traditional credit measures when determining whether policy measures to slow the housing market are necessary. They should instead focus more on debt-service ratios and other indicators related to debt servicing. As for central banks, they need to realize that if they cut their policy rate to stimulate the economy, the short-run positive effects of increased borrowing on both output and inflation have a downside in the long run as more borrowing eventually leads to higher debt servicing. In suggesting less emphasis on debt ratios and more on debt service ratios, we by no means want to imply all is well. The debt service ratio is on the rise today. The only other time it rose in any sustained way over the past 25 years was just before the crash of 2008. Combined with increases in consumer insolvencies, which were up 9.5 per cent over the 12 months ending in December, the uptick in the debt service ratio should focus the minds of policy-makers. But, at some point there has to be an explanation for why we haven’t yet seen a U.S.-style housing market correction. The debt service ratio provides one important clue.
Steve Ambler is David Dodge Chair in Monetary Policy, C.D. Howe Institute, and Professor of Economics, École des sciences de la gestion, Université du Québec à Montréal. Jeremy Kronick is Associate Director, Research, C.D. Howe Institute.