The Reminder is making its archives back to 2003 available on our website. Please note that, due to technical limitations, archive articles are presented without the usual formatting.
A new report from RBC Economics shows that the popular perception that North American households are veering towards disastrous debt levels is totally unfounded. Instead, the report says, the biggest risks for households relate to housing and auto demand, and how rapidly they redeploy their investments. "The prevailing outlook on North American household finances underestimates employment, personal income and productivity growth," said Derek Holt, assistant chief economist, RBC Economics. "While there is room for caution, too much emphasis is being placed on highly flawed measures and misled beliefs that overstate the risks to the economy." The RBC report notes seven widely held myths about North American finances: Myth No. 1: North American households are in over their heads in debt. Fact: This falsehood is based on the debt-to-income ratio, which measures the total amount that an individual owes compared to what they earn. This measure is flawed because it compares an individual's total debt to a single year's income, rather than over one's lifetime of income. Borrowing patterns indicate that households usually borrow out of future income to satisfy housing and other spending needs, and do not borrow with the expectation that all of that debt has to be paid back out of that single year's income. Furthermore, comparing debt to income does not take into account how debt is used. At present, North American households have about six times as much invested in assets compared to total debt. This suggests that the vast majority of debt is used to acquire assets such as real estate, rather than on expenses that do not provide potential returns. Indeed, debt as a percentage of total assets has remained remarkably stable over the decades. See 'Concerning' P.# Con't from P.# A rising debt-to-income ratio merely demonstrates that capital markets in North America have become much more efficient and have fed economic development in the process - in contrast to many developing economies. Myth No. 2: Consumer bankruptcies keep getting worse. Fact: While the number of consumer bankruptcies in Canada and the U.S. has increased over the past decade in relation to growing populations, over the same period the total debt of bankrupt individuals expressed as a share of the growing economy has remained quite stable. Furthermore, the amount of bad debt that has been written off over the long-term Ñ relative to the growth in the amount of household lending - has also remained quite stable and trendless. This demonstrates that while more people are declaring bankruptcy, relative to growth in the economy and relative to growth in lending activities, bankruptcy trends have not materially changed over the past two decades. Going forward, improvements in the share of incomes that go towards interest and principal repayment on all types of debt should drive cyclical improvements in bankruptcy trends within normal long-term ranges. Myth No. 3: Growth in revolving credit products is a problem. Fact: Rapid growth in credit card balances and lines of credit since the late 1990s has raised concerns about households borrowing large sums of money and only meeting the minimum payment or interest requirements while postponing payment on the principal. This would pose the risk that as the principal grows larger and larger over time it may become a dangerous debt spiral. However, as interest payments as a share of income are small and falling, it suggests low interest rates are offsetting any effect of growth in revolving credit products. Additionally, as revolving credit products offer greater flexibility than more traditional term loans, their growth in popularity has come at the expense of fixed and variable rate loans and other cash management products. Myth No. 4: Households will be in trouble when interest rates rise. Fact: This notion is based on the belief that households are taking on debt at floating interest rates with the assumption that today's low interest rates will remain intact forever. With respect to the pace at which interest rates may increase over the next two years, RBC's view is that rates will, at most, inch upward. Conditions for a run-up in rates to levels that are comparable to the late 1980s are not present today and North American consumers' ability to manage debt will remain strong. Furthermore, a flight to more secure investments, after the stock market corrections that began in the fall of 2000, has resulted in U.S. liquidity standing at fairly high levels while Canadian households packed away record high levels of cash. If needed, the amount that Canadians have tucked away in chequing and saving accounts, money market funds, and cash holdings over the past three years alone could be redeployed to service up to a four percentage point increase in the debt service burden in Canada. Holdings of liquid investments are abnormally high at the moment. Myth No. 5: Households are not saving enough. Fact: A continual downward trend in the traditional personal saving measure has often sparked concerns about the inadequacy of household saving. However this measure does not reflect the fact that most households view their personal saving as savings from their income plus changes in the value of total assets, less changes to their total debt. While the conventional measure has dropped sharply during the past decade, the more complete wealth-adjusted measure has consistently showed approximately one-fifth of disposable income being saved by Canadian households. For example, while they save little off of their paycheques, Canadians are watching their house values climb while paying off their mortgages. In the U.S., the wealth-adjusted personal saving rate dropped sharply into negative territory after equity markets began correcting in the fall of 2000, but during the past few quarters, it has climbed back into positive territory. Myth No. 6: Households are frivolously spending their home equity. Fact: Against this myth is that for the past four years, Canadian home equity has been rising - not falling - while net equity on all other assets has been falling. Thus, the average Canadian household is building up home equity despite anecdotal evidence of some first time homebuyers minimizing down payments or spending home equity to finance other purchases. In contrast, home equity in the U.S. has been falling, but with good reason. The 1986 U.S. Income Tax Act ended the tax deductibility of non-mortgage debt but continued to allow deductibility of mortgage interest against taxes. This tilted preferences towards using mortgage debt instead of consumer credit to meet consumption choices. Over the past few years, through one wave of mortgage refinancing after another, mortgage lending has grown rapidly as non-mortgage lending has slowed down sharply. Hence, running down home equity by taking out bigger mortgages and shying away from non-mortgage loans represents rational activity by U.S. households seeking to lower their after-tax cost of total debt. Going forward, the likely end to refinancing waves will mean that U.S. households will probably feed growth in consumer expenditures by returning to borrowing through non-mortgage loan products. Myth No. 7: Falling equity prices hurt credit quality. Fact: North American households were hit hard as equity markets corrected in 2001 and 2002 before recouping a part of the losses in 2003. However, finances have greatly improved for the average North American household. According to the U.S. Federal Reserve 2001 Survey of Consumer Finances, middle-income households had more invested in property markets than equities at the beginning of the market correction proving that middle-income households have benefited from strong property markets and the lowest interest rates in history. The same circumstances are true for Canadian households as well.
