Canadians are no strangers to debt anxiety.
We have long fretted over rising household borrowing, but during COVID, cheap credit, a wave of government money and rising household savings seemed to put us on better footing. Delinquency rates declined and insolvency claims sank way below pre-pandemic levels.
Now as the Bank of Canada embarks on a hiking cycle that could go faster and further than before, and sky-high inflation squeezes household budgets, economists are once again raising the red flag on debt.
“As interest rates turn from tailwind to headwind, higher debt servicing costs could spell financial troubles for some households. Credit performance indicators, such as insolvency and delinquency rates, which saw significant improvement during the pandemic, have likely hit their trough and will begin to trend higher in the face of rising interest rates and surging inflation,” wrote TD economist Ksenia Bushmeneva in a recent report.
So how bad is our debt?
According to Capital Economics, Canadians’ household leverage has now reached levels as high as those seen in the United States just before their housing crash.
Even before coronavirus, Canadians held a significant amount of debt, but we piled it on during the pandemic, bingeing on cheap credit.
Capital says household debt hit 170% of disposable incomes in Canada at the end of 2021, up from 164% just before the pandemic and 135% when the financial crisis hit in 2008. For comparison, US household debt is now at 139% of disposable income, about the same as before the pandemic and down from the 172% seen in 2009.
“So Canada has finally matched the household leverage that preceded the housing collapse in the US,” said Capital economist Paul Ashworth.
Low interest rates kept debt servicing costs down during the pandemic, but that is about to change. TD’s Bushmeneva says Canada’s debt service ratio is on track to exceed its pre-pandemic peak by the end of 2023, leading to Canadians spending an additional $43 billion on debt servicing over the next two years.
At the same time decades-high inflation is squeezing household budgets.
Canadians are feeling the pinch. The MNP Consumer Debt Index out this morning found that more than half of Canadians surveyed say they are already feeling the effects of higher interest rates. Almost 40% say that rising rates could drive them closer to bankruptcy, up four percentage points from December.
“The affordability crisis, fuelled by rises in the cost of living and interest rates, is increasing the financial pressure among Canadian households,” said Grant Bazian, president of insolvency firm MNP LTD. “Many are likely to rack up more debt to keep up with the rising costs of their daily expenses, but as interest rates rise, so will the cost of servicing some of those debts, making it more difficult to pay them down.”
The good news is households are entering these trying times in a position of strength, says TD’s Bushmeneva. The labour market is tight, wages are rising and household net worth has risen by almost 30% since the end of 2019.
Another plus is that while households took on more mortgage debt during the pandemic, consumer credit declined. Mortgages, which amortize and have more predictable payments, reduce exposure to interest rate surprises, said Bushmeneva.
Still higher debt servicing costs coupled with rising consumer prices, particularly for food, gas and rents, threatens to squeeze the budgets of low-income families, undoing the improvement in financial health seen through the pandemic.
Debt remains a key vulnerability and a reason for the Bank of Canada to tread carefully, say economists.
The Bank of Canada’s two hikes this year have pushed the rate from 0.25% to 1%. Many expect another 50 basis point hike in June and more to come as the Bank makes it way to the “neutral rate” somewhere between 2% and 3 % — or, as some predict, even higher.
Capital, however, doubts the Bank will be able to go much beyond 2%, because of Canadians’ debt.
“The problem is Canada’s over-reliance on housing and household debt which, together make it the country most susceptible to the impact of higher interest rates,” said Ashworth.