Borrowing from Aesop’s fable from the ant and also the grasshopper, I see Canada like a country covered with ants (i.e. prudent, hard-working savers). Yet one would never know it judging from how certain high-profile statistics are bandied about.
When ‘good’ debt goes ‘bad’: Why it can be dangerous to categorize that which you owe
Eat a handful of almonds or bite into a treat and your body will gain weight in the same rate. A calorie is really a calorie, whether or not this came from a ‘good’ fat or perhaps a ‘bad’ one. Why is debt different? Read on
For instance, we are constantly reminded that the household savings rate is declining. It took Malcolm Hamilton to point out (in his recent paper for the C.D. Howe) that we are actually saving considerably more let’s focus on retirement than we were Twenty five years ago. Your family savings rate is a sadly misunderstood metric that’s basically irrelevant when gauging our true saving habits.
Another statistic that is frequently misused is the level of household debt. Rising personal debt is generally regarded with great consternation and yet the numbers published by Statistics Canada paint a great news story when viewed in the right light. It is a fact that the median debt of indebted families increased from $37,000 to $60,000 (in constant dollars) between 1999 and 2012. On the other hand, the median assets of households with debt rose by $180,000 in the same period. Indebted households got considerably richer in spite of their greater debt load.
But this is not news to anybody who reads beyond the headlines. What might be more surprising is the fact that the majority of the debt is “good” debt: Of the $1.3 trillion of debt owed by Canadians this year, a level trillion dollars (77 per cent) was mortgage debt.
Indebted households got considerably richer in spite of their greater debt load
Provided the mortgages can be serviced, making mortgage payments is no different in principle than putting money into one’s RRSP. In both cases, an asset is being built that will prove useful in retirement. You will never tap the equity in your home, but it’s best to know that can be done if necessary; for instance, to fund long-term care after your life or to downsize your residence to be able to convert some of that home equity into extra retirement income.
There is another less obvious reason mortgage debts are good debt: reducing the mortgage suppresses personal consumption. It forces homeowners to consider a more modest lifestyle compared to what they otherwise would be inclined to pursue. If paying off the mortgage is a long-term proposition (which it is, for most of us), the mortgagee gets accustomed to spending less and, consequently, needs less income after retirement to keep that same lifestyle. People with an acceptable quantity of mortgage debt are ants, not grasshoppers.
Consider a simple example: A family group with $100,000 in combined earnings that’s paying $20,000 annually in tax; $5,000 in a variety of payroll taxes; $10,000 in child-raising expenses; $10,000 in retirement saving; and $15,000 toward the mortgage. If the household is living within its means and takes care of the mortgage by retirement (and the kids have left home), the couple will require just $40,000 a year after retirement (net of income tax) to maintain their lifestyle. With no mortgage, they would have needed $55,000.
A form of debt that isn’t quite as virtuous as mortgages however is not necessarily “bad” is debt that is used to invest in some type of investment, for example a good investment property or financial assets, for example stocks or bonds. Also in this category are student education loans, which may be considered an investment in one’s career. Investment-related debt doesn’t necessarily result in a positive outcome, but at least it is done using the better of intentions.
Descending one level further, we come across a form of debt that can generally be looked at “bad”: personal debt. For example any debt that is a result of augmented consumption. Besides consumer debt not build a usable asset, its other shortcoming is it expands personal consumption in a way that may prove unsustainable later in life. A few with ongoing consumer debt becomes familiar with to the next stage of spending during their working years than they will be able to afford after retirement. Notice this is the opposite of mortgage debt.
The ugliest form of consumer debt may be the type that’s financed by charge cards that one cannot consistently pay off every month. With annual credit card interest rates near to 20 percent, it doesn’t take an ant to realize this situation can only lead to grief.
With this categorization in mind, we are able to cast a few of the household debt statistics inside a new light.
Between 1999 and 2012, households led by someone aged 55 to 64 experienced an average rise in personal debt of $17,900, but this was totally dwarfed by a typical increase in assets of $344,500! Even if one ignores the portion of the rise in assets because of higher property values, average household assets still increased by $199,500 during this period. Older households fared better still. That’s the reason we need to be cautious about funnelling more income into retirement savings. It’s the younger households that need help because they are the ones struggling probably the most simply to make ends meet.
As to whether mortgage debt can be “bad” debt, the answer is absolutely. A home equity line of credit, for example, might look like plain vanilla mortgage debt but it is actually personal debt in disguise. The eye charges may be lower, but that doesn’t alter the proven fact that the line of credit is being used to live a little beyond one’s means. Another risk with mortgage debt is which you may lose your job and be unable to make the mortgage repayments. Or you might attempt to buy more house than you should and go ahead and take largest mortgage possible with no cushion for a future rise in rates of interest.
Finally, house prices may fall, a situation that is already a real possibility in Calgary and an ongoing concern in Vancouver and Toronto. Our troubles in everyday life begin whenever we seek permanence; we ought to not think that house prices will rise forever.
Even with these caveats, we should rest easier understanding that most Canadian household debt is mortgage debt instead of personal debt. Ants and grasshoppers will both continue to accumulate debt over the course of their lives – the main difference is that ants will gravitate toward the good variety.
Frederick Vettese is Chief Actuary of Morneau Shepell and also the author of “The Essential Retirement Guide: A Contrarian’s Perspective,” published this past year by Wiley