The human brain struggles with distinguishing between a real or imagined threat.
Is it a snake? Or just a shoelace?
One may kill us quick, and so we react fast and think it through later… or maybe never.
Is the often cited, rarely critiqued, ‘debt-to-income’ ratio a snake or a shoelace?
A killer lying in wait or a meaningless footnote?
Federal regulators, and most mainstream media, would have us believe that at 167% it’s an Anaconda slithering through our sheets while we sleep, readying to swallow each household whole.
Two key points often absent from the debt-to-income conversation:
1. The average household debt figure is largely irrelevant to the financial success of our individual household(s)
2. What is my own debt-to-income ratio? And am I worrying about it at, say, 500%?
Perceived Reality
If one were to stop a citizen on the street and ask them if they believe today’s low interest rates have allowed Canadians to borrow more money than they should have most would say yes.
If one were to stop a citizen on the street and ask them if they believe today’s low interest rates have allowed housing prices to rise too high too fast, most would say yes.
If on the heels of these two questions you then asked one more question: Should government step in and tighten regulations?
Most at this point with this context would say yes.
And these citizens would be wrong.
Also by “yes” what these citizens mean to say is “regulate my reckless neighbours – not me, I’m cool.”
Framing matters
Let’s ask a few more questions.
Would it sound reasonable to take on a $2,000 mortgage payment with a household income of $100,000?
Is it fair to say that the same $100,000 per year household income could support a $2,600 monthly housing payment?
Likely we are going to get a “yes” response to both of these questions. As indeed these numbers are reasonable by any measure.
Numerical Reality
The $2,000 per month payment represents a monthly payment at today’s interest rates on a $500,000 mortgage balance.
Ah but what if rates double you ask? What if indeed…
The $2,600 per month payment represents a monthly payment at double today’s rates (when that $500,000 mortgage balance comes up for renewal).
Readers quick with numbers can see where this is headed, this household with their $500,000 mortgage balance and a $100,000 household income has a debt-to-income ratio of 500%.
Are they freaking out, suffering desperate times, readying a kidney for sale?
Not at all.
To be fair they do have concerns about debt levels – your debt levels!
The 500% debt-to-income household has things under control; they know that ~$1,000 of that ~$2,000 payment is principle reduction, a forced savings plan. They also know that the ~$1,000 interest component per month (fixed for the next five years) is way less than what they were paying in rent last year, and unlike rent this expense will not rise for five full years…and their mortgage debt balance will be dropping steadily. (by ~$60,000 over the first five years).
How many renters will see a ~$60,000 increase in net worth over the next five years? (this amount assumes 0% movement in home prices)
Nonetheless citizens remain concerned. Concerned that today’s low rates have allowed you to borrow more than you should have – and as you know, you are A-OK.
Guess what, your neighbours are OK too.
They are OK with a 500% debt-to-income.
Although few in Canada actually have a debt-to-income ratio this high; in fact Bank of Canada research shows that just 8% of Canadians have a debt-to-income ratio above 350%.
The example used in this piece is in fact a complete outlier, and not at all the norm; we are far more conservative than even these comfortable figures.
Tomorrow we discuss houses, in particular – glass houses and those who reside in them.