A paid off home has long been considered a fundamental of a good financial plan and something I hope to accomplish in my thirties. Currently 3 years into the first 5-year mortgage term with my lender, I have no plans to refinance and incur the associated financial penalties to lower my rate a few points. However, I do like to keep note of current lending rates and if you are a Canadian, you probably heard that the Bank of Canada cut it’s key overnight lending rate by 25% this week. While the jury is out on whether this was a good move for Canadians, my preoccupation with lending rates in general is purely out of curiosity as it has little bearing on my current financial plan. If the rates were to move sharply, whether up or down, my plan would be the same: to continue to pay off my mortgage as quickly as possible. Before I get into why, let me back up a little.
A recap on mortgages
When buying a home, the vast majority of us do not have the full amount saved up since a house can cost hundreds of thousands of dollars. Because we may not want to wait until we save that much, and need somewhere to live in the meantime anyways, most of us borrow money from a lender and finance the purchase over a period of time. Canadian Government insurers cap the max payback period at 25-years. The bank of course doesn’t offer this service for free, so as we work on paying back the money we borrow, the bank will make us pay a little extra as their fee. The banks call this fee “interest” and how much it is as a percentage, is called the interest rate.
There has been much buzz lately about how low current interest rates are. I remember being told stories by my parents of how lending rates used to be so much higher. But comparing those tales with stories of having to walk 5 miles to school, up-hill, BOTH WAYS… well… let’s say I didn’t always take such stories at face value. I decided to look into the claims for myself. It turns out that the information was easy to find since the Bank of Canada has a number of historical interest rate records available on their website. One document in particular lists the average posted interest rate, charged by major large banks at the time, for a 5-year term residential mortgage. I’ve turned their table into a more visually friendly graph below:
The time-line shows us that through the 1950’s, when they started collecting the data, until the mid 60’s, rates were pretty steady between 5-7%. However, around 1965 rates started to rise.. and rise… and rise. This continued for nearly two decades until the early 80’s when they peaked at over 20%! Since then, except for a few blip years, the rates have trended lower and lower each decade to their current level under 5%. My parents weren’t kidding, there is a big difference between when they bought their house with rates over 10% to when I bought mine at less than 5%. Considering the oldest millennials were born at the start of the 80’s, my generation has seen the cost of borrowing a dollar become cheaper and cheaper each year.
With such low rates, Canadians must be wiping out their debt
This got me curious as to whether the lower costs of borrowing has helped Canadians wipe out their debt. If you had borrowed money in the past and renewed recently, the cost to borrow that same amount should be much cheaper now, making it easier to pay off. My gut told me that this might not be the case, but wanted to see if I could find any data on it. I ended up finding some good information on household indicators while on the Statistics Canada website. The data was only available from 1990 onward so I worked with what I could find. I started by looking at income. I was pretty sure that Canadians make more now then they did in 1990 and I was right. From 1990 to today, disposable income has almost tripled. Disposable income is the money left in your bank account after you have paid government taxes and deductions. In simple terms, it is the money controlled by you to save, spend or invest as you wish. While growth hasn’t been uniform across the provinces, on a whole, Canadians have much more disposable income than before. While our collective income has risen substantially, two key debt ratios haven’t changed nearly as much. These are the Consumer Debt Service Ratio and the Mortgage Debt Service Ratio.
What is a debt service ratio?
Skip this section if you already know, otherwise read on. A “ratio” simply means one number divided by another. To calculate a Mortgage Debt Service Ratio, you would take all of your Mortgage Payments for the year and divide that number by how much Disposable Income you generated. The answer will be less than one (otherwise you didn’t make enough to pay your debts) so multiply by 100 to get the number as a percent. The same calculation can be done for consumer debts; things like credit cards balances, car loans and the payments on the bedroom set you financed but didn’t have to start paying on until 2015. Adding all debt payments together and dividing by your total disposable income for the year calculates your Debt Service Ratio and gives you an idea of how much of your income goes towards paying off things you have already bought. If this number is zero, you have no debt. If this number gets too big, you won’t have enough money left over to pay for things as it will already be spoken for by your lenders. Governments and the Bank of Canada are interested in numbers like this, as it allows them to set lending rates to ensure the Canadians don’t get in too much trouble as a whole.
The big chart
In addition to the historical mortgage rate chart above, I decided to add the income and debt service ratios to the same chart for some visual comparison.
The green line shows total Canadian disposable income tripling since 1990. At the same time, the percentages for mortgage (maroon dashed line) and consumer debt (orange dashed line) converge below 4%. Combine the debt ratios together and you get the total debt ratio (red dashed line) which starts around 11% and moves to 7% over the same time-frame. So at first glance, it looks like debt has fallen since 1990. This can be a little misleading, debt as a percentage of disposable income fell, but because disposable income increased so quickly (and faster than the debt service ratio declined), the amount of debt in dollars actually nearly doubled (pink line)! In addition, the part of the debt percentage that fell, was the part from mortgages, which can be attributed to the fact that mortgage rates fell so much over that same period and not from Canadians actively working to eliminate debt.
Why should I care?
Servicing debt takes money out of your monthly budget. Very low interest rates like we are experiencing today, can cause us to think that the payments on a high amount of debt are easy to manage. At the same time, low rates don’t really promote saving and investing. The problem is low rates may not last forever. The first mortgage rate chart above will attest to this fact if you look at the period from 1960-1980! If you had purchased your first house in 1977 and had to renew in 1982 (after a 5-year term) you were in for a 5-10% shock! If you hadn’t paid off enough principal to offset the increase in monthly payment, your house may have no longer been affordable. I never want to be in a position where I cannot pay what I have agreed to. The Bible even uses some harsh language towards people who do this.
The wicked borrows but does not pay back,
but the righteous is generous and gives;
-Psalm 37:21, ESV-
boring borrowing advice
Some popular borrowing advice I have heard a lot lately goes something like “I’ll borrow now, since the cost of borrowing is so cheap and if the rates go up, I’ll pay it off then.” As someone who wants to manage and grow their wealth, not their debt, I think this conventional wisdom is completely backwards. I would advise a different strategy with regards to your debt. Pay it as fast as possible! Regardless of what the rates are. In fact, while rates are low, more of your payment goes towards the principal amount and less towards interest payments which gets you out of the debt even faster. If borrowing rates do go up, this further benefits you in one of two ways:
- If you still have debt when rates go up, the principal debt will be smaller, so even if the interest rate is higher, the interest payment will be lower because the outstanding amount is lower and you can still afford to service the debt.
- You are even better if you have no debt left when rates go up. You will have freed up all of the income you normally would have had to put towards debt payments and can invest it at a time when rates are higher – growing your money faster!
Looking at the charts above, this advice will certainly contradict the actions of many of your friends and family. Personally, I would rather be in a position to be righteous and give generously than be stuck with a debt I am unable to pay.