Why the Debt to Income Ratio is not a Problem in Canada

The debt to disposable income ratio is at or near record highs in Canada.  In twenty-five years the debt to income ratio went from 0.89 to 1.63.  At first glance it looks like most Canadians are probably struggling with debt.
    Your debt to disposable income doesn't exactly give you an accurate picture on your financial situation.  Your income to debt interest ratio and your debt to assets can be a much better way to gauge your financial health.
    Someone that earns $30,000 and has $48,900 in credit card debt with only a couch and a TV as their assets is in much rougher shape than a Canadian that earns $30,000 with $48,900 remaining on a 2.7% mortgage amortized for six years on a $300,000 house.  The first Canadian has a debt to disposable income ratio of 1.63, a debt to asset ratio of 33.2, a disposable income to debt servicing ratio of 0.33+ and pays 33% of his income on interest.  The second Canadian has the same 1.63 debt to disposable income ratio, a debt to asset ratio of 0.16, a 0.29 income to debt servicing ratio and will pay 4% of his income on interest.
    The amount of debt you have is important, but the cost of your debt and what you are buying with your debt is equally if not more important.


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Credit Card Nerd Math

The percentage of disposable income that is used to pay interest on Canadians household debt has not changed much since the early 90's.  The debt to asset ratio hasn't changed much neither, we as a nation on average have five times the assets as we have debt.
    In 1992 Canadians had a 0.92 debt to disposable income ratio, a 7.5% prime rate, a 0.17 debt to asset ratio and an interest servicing ratio of 0.07 at the prime rate.  A Canadian with an after tax income of $35,000 would be paying $2,070 a year on interest or about 7% of his income.  The math works like this; 7.5% (Prime Rate) x $27,600 (Debt) ÷ $30,000 (Income) = $2,070.
    In 2000 on average Canadians had a 1.10 debt to disposable income ratio, a 6.75% prime rate, a 0.15 debt to asset ratio and an interest servicing ratio of 0.07 at the prime rate.  A Canadian with an after tax income of $40,000 would be paying $2,970 a year on interest or about 7% of his income.  The math works like this; 6.75% (Prime Rate) x $44,000 (Debt) = $2,970.
    In 2006 Canadians had a 1.33 debt to disposable income ratio, a 5.25% prime rate, a 0.17 debt to asset ratio and an interest servicing ratio of 0.07 at the prime rate.  A Canadian with an after tax income of $50,000 would be paying $3,491.25 a year on interest or about 7% of his income.  The math works like this; 5.25% (Prime Rate) x $66,500 (Debt) = $3,491.25.
    In 2015 Canadians had a 1.63 debt to disposable income ratio, a 2.7% prime rate, a 0.19 debt to asset ratio and an interest servicing ratio of 0.04 at the prime rate.  A Canadian with an after tax income of $55,000 would be paying $2,420.55 a year on interest or about 4% of his income.  The math works like this; 2.7% (Prime Rate) x $89,650 (Debt) = $2,420.55.
    Below we have a chart with the prime rate, the average debt/income ratio, the average debt/asset ratio in Canada and the ratio of (Prime Rate x Debt) ÷ Income.  The last column shows you what the interest costs vs income ratio would be if all Canadians had the same debt to income ratio and if all debt was at the prime rate.



Prime Rate and Debt to Income Ratios

Year

Prime

Debt / Income

Debt / Assets

(Prime x Debt) / Income

1990

14.25%

0.89

0.18

0.13

1992

7.5%

0.92

0.17

0.07

1994

6.25%

0.95

0.16

0.06

1996

7.25%

1.00

0.16

0.07

1998

6.5%

1.07

0.16

0.07

2000

6.75%

1.10

0.15

0.07

2002

3.75%

1.12

0.17

0.04

2004

4.25%

1.22

0.17

0.05

2006

5.25%

1.33

0.17

0.07

2008

5.75%

1.47

0.19

0.08

2009

3%

1.54

0.20

0.05

2010

2.25%

1.59

0.20

0.04

2011

3%

1.61

0.20

0.05

2012

3%

1.63

0.19

0.05

2013

3%

1.63

0.19

0.05

2014

3%

1.63

0.19

0.05

2015

2.7%

1.63

0.19

0.04




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A Wake Up Call

Despite what anyone tells you, it has never been easy to buy a house.  In the past Canadians were paying the same percentage of their disposable income on interest.  The big difference is that in the past, Canadians that were saving more and paying down their mortgage quicker were rewarded more.
    The chart above shows the balance between interest rates and debt in order to have a reasonable income to interest cost ratio.  If we were going back to a 5.25% prime rate tomorrow, then you might expect to have the average Canadian house to be 18% less, taking fear and panic out of the equation.  If it took a decade to get to 5.25%, then your house could increase by 9.7% over that time period.  At 3% income growth, the average house might increase by (1.0310 x 1.33 - 1.63) ÷ 1.63 = 9.7% by the end of the decade if the prime rate increases to 5.25%.

Sources:
Debt to disposable income: http://www.statcan.gc.ca/pub/75-006-x/2015001/article/14167/c-g/desc/desc01-eng.htm
Historical Prime Rate: http://www.fin.gov.bc.ca/PT/bcm/ref/cibcHistoricalPrime.pdf
Debt to Assets: http://www.bankofcanada.ca/rates/interest-rates/canadian-interest-rates/

Additional Interesting Information
Only 5.8% of Canadians Debt is Credit Card Debt: Page 25 http://www.bankofcanada.ca/wp-content/uploads/2014/12/bfs_december14.pdf
Debt Servicing Ratio 1990-2013 in Canada: http://www.statcan.gc.ca/daily-quotidien/141215/longdesc-cg141215a002-eng.htm