Affordability Is Not Absolute

The Fraser Institute recently pointed out that Canadian personal debt is at an all time high.  Mortgage debt alone is $1.23 trillion.

While that number is likely accurate, the issue of debt is a complex one and the insinuation that a high number is bad can be misleading.  There are lower numbers that will be bad too.

Our grandparents and parents had no love for the amount owed.  Now affordability is the measure.  If I can afford the debt, it is benign.  No reason to feel bad about owing $400,000 on a mortgage if the monthly payment is $1,800 and that represents only 25% of family income.

Affordability hides an important problem.  The amount of debt is absolute, while affordability is relative.  Affordability depends on two things:

  1. The interest rate applied to the absolute amount of debt
  2. The family income

Relative things can change.  If they change adversely, affordability can disappear in a moment.

If someone loses their job or must take a pay cut, (could be as simple as no bonus or less overtime)  affordability becomes a challenge.  Total income is distributed many ways. To the government, debt payments, pensions and other deductions first, with people living on the rest.  If income shrinks a small percentage, living shrinks more.  Everyone recognizes that reduced income imperils affordability.

I am not so convinced that people clearly understand what happens if interest rates change.  There is a devastating convergence of adverse effects.

The simple one is that if rates rise to what would be historic lows prior to 2008, say 5%, the “affordable” monthly payment of $1,800 would become $2,225 on renewal of $338,000 remaining after five years.  Maybe income will have risen enough to make that affordable too, but no certainty.  If your job depends on a buoyant real estate market or construction, then what?

Terror inducing is the rate, considered low in 1968 or so,  7%.  Now the payment is $2,600 on the remaining balance.  If you like horror movies, try 1982 at 18%.  $5,000+.

The second problem is you can’t get out.

Affordability again.  The person you will sell to, must find the home affordable.  If you don’t like the payment at 5% no one else with your income will either.  The way they can make it affordable is to pay less for the home and thus make the mortgage fit their budget.

The amount you owe is absolute, so any price reduction comes out of your apparent equity.  Relative equity I suppose.

Do not buy into the idea that if prices fall, the house you want will be cheaper too, so no matter.  That would be true if your equity stayed the same or even fell proportionally. 

Then there are transaction costs to sell and buy another and your income must be unaffected by a primary part of the economy being in trouble.  None of those are possible. A 20% drop in price and costs could erase all the equity. No down payment on the next purchase.

Work this one through with a pencil or spreadsheet.  The margin for error is quite small and results are devastating.  To fear debt in terms of what you owe is not a crazy idea in today’s economy. 

Affordability is a trap.

Don Shaughnessy is a retired partner in an international public accounting firm and is now with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.

Contact: don@moneyfyi.com  

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