Assessing Your Financial Sensitivity To Changes In Interest Rates by Gareth Watson, CFA Twitter profile & website
Interest Rates – we know that they are the cost of borrowing money. But do you or your children truly understand the impact that interest rates have on personal finances and can you answer any of the following questions:
- How much debt do you have?
- Do you know what interest rates you pay on that debt and are they fixed or variable?
- If any of your debt is variable, how much more would you pay if interest rates increased marginally or materially?
- At what interest rate could you no longer afford your current debt level?
Interest Rates
You might consider some of these questions straight forward, but bluntly put, we doubt many Canadians actually know the answer to all of them. If you are such a Canadian you can take some comfort in knowing that you’re not alone. However, if too many Canadians find themselves in this position it could create some financial and economic problems down the road when interest rates rise.
If you follow interest rates on a regular basis you’ll know that they are currently at historical lows and have been in decline for many years. Today’s younger generation is only familiar with single digit lending rates as opposed to the double digits seen in the late 1970s to the early 1990s. When interest rates fall, borrowing money becomes less expensive, lending increases, spending increases and in many cases asset values increase. As an example, look no further than the Canadian housing market as housing prices, and debt levels for that matter, have climbed to such a high level in some places that there is concern about what might happen if interest rates were to rise. Recent data from Statistics Canada indicates that total household debt, which includes consumer credit, and mortgage and non-mortgage loans, totaled $1.933 trillion. $1.268 trillion, or 65% of that amount, came in the form of mortgage debt.
To put things into perspective for Canadians take a look at the chart that compares Canada and U.S. household debt to disposable income. In 1990, Canadians owed 85 cents for every dollar of annual disposable income they had, today that number has grown to north of $1.65. In other words debt levels have been growing at a faster rate than our disposable income. The chart also shows that the ratio has declined in the United States since the 2008 financial crisis while it has increased in Canada.
What is more concerning is that the increase in household debt appears more concentrated with younger people. The Bank of Canada estimates that12% of households are “highly indebted” or have a total debt-to-gross-income ratio above 250%, but more shocking is the statistic that this 12% holds approximately 43% of household debt in Canada. So the concerns over household debt are not widespread across the entire population, but appear to be focused more on Canadians aged 21 to 35, especially those living in British Columbia, Alberta and Ontario where property values are comparatively higher. Demographics suggest Canadians should be concerned about this situation as we tend to spend less as we age, so the onus to consume to help grow the economy is expected from a generation that may have already exhausted some or all of its access to credit.
To read more about consumer debt, including financial threats for younger Canadians and to perform a quick debt sensitivity exercise please find our full Consumer Debt & Interest Self-Assessment Report by clicking here.
Charts are sourced to Bloomberg unless otherwise noted.
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