Are CDN Debt Levels All That Bad?

Two stories in the media today that continue to clarify the picture of what kind of debts Canadians are facing and how the government is approaching the situation.

First off, a report from TransUnion credit union shows average unsecured, non-mortgage credit “…floated up 1.4 per cent in the fourth quarter last year to $25,960.That reversed three consecutive quarters of flat growth or reduction on everything from credit card debt to lines of credit, consumer and car loans. TransUnion officials note that the slight increase in average consumer debt at the end of 2011 is in line with historical increases in debt during the Christmas shopping season.” The report could mitigate regulator and lender concerns that Canadians are recklessly racking up huge amounts of debt, however…

…The Bank of Canada released research on Thursday that reiterated its concerns with household debt levels, particularly in the face of any slowing or retreat in housing values. The bank states that “…rising house prices can facilitate the accumulation of debt so that a drop in prices can represent a significant shock for households.” That headline can be found in the introduction to the 56 pages of data and analysis released online HERE.

Are the BoC’s concerns over debt levels justified? There is a fundamental problem, in our view, with how this data is being treated. While the debt-to-income level is rising, the relationship between that ratio and the equity available to the debt holder is not (chart 2b on p.20 of the report). When the US housing market crashed, customers were able to secure loans for 110 or 120% of the value of their home! No matter what your debt-to-income ratio was, a housing market correction was going to put you underwater big time. In Canada, most homes are still financed with about 20% down (80% loan to value), and the BoC review indicates a debt-equity ratio of less than .70 (70%), which means that a 10% correction would still leave the average Canadian homeowner with equity in their home.

In other words, we think that consumer debt relative to equity is far more relevant to housing market corrections than their debt to income level. If your debt-to-income level is 150% or 160% or even 200%, but you have 200k equity in your 400k home, than that ratio is far less concerning.

In our opinion, the BoC’s concerns, along with those of OSFI (which regulates the banks), the Minister of Finance, and CMHC are overly predicated on a ratio that does not tell the whole story of borrowing in Canada. Increased regulation and reduced pricing could therefore unnecessarily tighten lending and penalize consumers whose debt is far more manageable than the debt-to-income ratio would suggest.

You can read about the TransUnion report in the Globe and Mail HERE.

The Globe’s take on BoC study release can be found HERE.

The BoC report itself can be found HERE. It’s a large piece of work but contains some fascinating insight and data.

Renos, Refinance, and Resale Value

With Spring around the corner and rates still at near-record lows, many Canadians are gearing up to tear down, rebuild, and renovate all or part of their homes. From basements to bathrooms, this is the time of year when contractors’ phones start to ring off the hook as homeowners (or home buyers) take a long, hard look at what needs to be done.

Before you embark on your renovation journey, we thought we’d bring up a few things to consider on the financial side of the equation…

First off – start with a budget and stick to it. Never start ripping up walls without knowing what you have available to spend, and what you can do with those resources. Get multiple contractor estimates as a first step for major renovations; for minor work, take the time to plan it out and then find out how much materials will cost (it is amazing what you can save by shopping around). Make sure you leave some resources (credit or savings) available for contingencies – 20% of estimated costs is a good start.

(Note – if you are looking to buy a new property and renovate right away, read up on your options HERE)

Second: prioritize the work that needs to be done. If you are renovating to improve your quality of life, try to determine which work needs to get done first. You likely have a limited amount of cash/credit to spend, so set it aside in chunks (and remember there’s always next year).

Third: If you are updating your home in order to put it on the market, consider what your renovation investment could mean to the potential resale value of your home. There is a neat website provided by the Appraisal Institute of Canada that can give you a sense of resale impact. Simply follow the guide, punch in how much you’re thinking of spending, and the program will give you a sense of We have a few issues with the program – it doesn’t take into consideration interest costs required to finance the work, depreciation of the work between when it’s done and when you sell, location of the home, or other factors – but it will give you some additional insight into resale value BEFORE you start knocking down walls (and paying for it). You can find the website HERE.

Fourth: if you are planning on undergoing major renovations, look at your home finance picture BEFORE signing off on any contracts. There may be financing options (such as Purchase Plus Improvements financing or Line of Credit equity take-out) that will help you keep your savings without incurring dramatic interest costs. Putting your equity to work in order to get a better quality of life out of your home can be a great justification for renovating, but be mindful of the fact that, should you suddenly want/need to sell, all that equity may no longer be available to you for a downpayment, moving expenses, and so on.

Just like completing the work itself, paying for your renovations is all about knowing what needs to be done and how to do it. Speak to a qualified home finance specialist early in the planning process in order to ensure that your renovations are worked into your larger financial plan – and not the other way around.

Financing Conditions – Pros and Cons

The use, abuse, and avoidance of financing conditions is and has been a hot topic in the legal, real estate and home finance communities for some time. Over the last several years realtors and home buyers have been using fewer financing conditions when preparing offers of purchase and sale. Some buyers have benefited, and some have lost – a lot. Part of the decline was driven by the need for a competitive edge in multiple offer situations, and some of it has been driven by the notion that financing has somehow become more easy and predictable in a world of online resources and record-low rates.

In reality, financing a home purchase has never been more delicate and UNpredictable than it has become over the past three years. Since 2009 we have seen a growing burden of lending policy, a switch in qualification calculations from using discount to posted rates, a shift in appraisal values and a withdrawal of products and offers from the market. Some of the challenges facing self-employed buyers, as an example, can be found HERE.

Each of these factors can throw a wrench into your financing plans, which isn’t the end of the world if you are looking at your financing situation before you buy, but can cause a lot of stress and money if you only address it afterward. Your first defence against buying a home you can’t afford is pre-qualification, which we discussed HERE. You should also consider finding and speaking to a real estate lawyer before looking at homes. An offer of purchase and sale is a legal contract with far reaching implications. A lawyer should be able to quote you what it will cost to close your purchase, as well as provide some preliminary advice on what this (and other) conditions mean to you.

However, we know that impulse buys and busy schedules can impact your preparation, so with that in mind, let’s take a look at what a financing condition is and why you should consider including one in your offer.

A financing condition typically allows the buyer 3 to 7 banking days to obtain a financing approval from a financial institution. An example of the language used would be: “This Offer is conditional upon the Buyer arranging satisfactory financing, at the Buyer’s expense, within 5 Banking days of acceptance of this Offer, failing which this agreement shall become null and void and the Buyer’s deposit shall be returned in full, without interest or deduction. Buyer reserves the sole right to waive this condition.” The condition should state an appropriate amount of time (remember that while bank branches may be open on weekends, their underwriting centres typically are not, and some holidays apply to banks that may not apply to you, so plan accordingly) that balances your needs with the perceived (or stated) timing needs of the sellers. Once you have a formal notification or letter of financing approval that you can work with, you sign off on a waiver of the condition and the realtor advises the seller’s side.

A financing condition is important because it protects your interests and provides you a safe exit should you not qualify for financing in the manner and amounts which you intended or can afford. An important word in the condition is “satisfactory”. It implies that if you only qualify to purchase the home with a bigger downpayment, or at a higher rate, you do not have to proceed with the sale. (Never state a particular amount in the condition or qualify it in any other ways than shown above; this condition is YOUR failsafe against not being approved to finance the home). A real estate lawyer in your jurisdiction will provide the best sense of what you can or can’t do given the particular wording of the condition.

Another “pro” of a financing condition is the flexibility it provides should the property not qualify for financing. If, for example, the home is appraised well below the purchase price by the lender, the financing condition allows you to accept the bank’s decline at the figures you requested, OR to try to make the deal work before walking away from it (asking parents for a gift to help with the deposit, bringing on a guarantor, etc.). Short appraisals are becoming more prominent as banks look for ways to tighten lending without hiking rates, and can be extremely difficult for borrowers to handle if they do not have the savings to manage it. We discussed short-appraisals and provided a financing example HERE.

(Keep in mind that a bank may approve your purchase conditional on an appraisal that may not happen until after the condition expires; in this situation, you must either be willing to accept the risk that the appraisal will come in on target and/or that you can handle it if it comes in short, OR deem the approval “unsatisfactory” and request your deposit back. Again – speaking to a mortgage specialist BEFORE you buy is the best way to prepare for this eventuality)

Remember that a financing condition in the contract does require you to formally and in good faith seek financing approval; don’t think you can just cite the condition if you get ‘cold feet’ or find a home you like better. Unless you can demonstrate that you sought out but were not approved for financing on terms you could afford, you may be sued for breach of contract.

Financing conditions are particularly important if you are planning on buying a property that needs extensive repairs or renovations, since the current value of the property (and the potential value of the renovations you plan to do) may be difficult to determine. Buyers thinking of acquiring “purchase plus improvements” financing should always talk about their finance plans before making an offer and should consider getting any contractors in line before making the purchase so that they can see and estimate the work within the condition period.

If you do NOT include a financing condition and cannot get approval to finance the property, the problems are serious and potentially very expensive. If you cannot get approval at a “tier 1″ lender, you may have to go to the secondary or private market for full or partial financing, which can cost you in terms of interest rates (12% instead of 4%, for example) and set-up fees. If you are unwilling to incur those costs or nobody is able or willing to lend on the property (because of its price, a zoning infraction, urea formaldehyde insulation, knob-and-tube wiring, etc.) you may have to surrender your deposit, but you may not be able to get out of the deal. Before getting caught up in a bidding war, speak to your realtor or lawyer and find out what the “worst case scenarios” are if you buy unconditionally.

Because it protects the buyer’s interests, the financing condition can be portrayed as having “cons” as well. An offer with a financing condition may get dismissed out of hand in a multiple offer situation, even if the price offered is the one to beat, simply because the seller or their realtor don’t want to risk a deal falling through. A financing condition that is longer (7 days instead of 3, for example) may also convey risk that the seller or their realtor don’t want to engage. Bear in mind, however, that both of these perceived “cons” impact the seller more than the buyer; a financing condition is about YOU and your ability to get financing for the home you want to buy. Winning a multiple offer situation and then having to re-sell the property six months later because you can’t afford it (or had to get private financing to mortgage it) is not, in our opinion, worth the cost or the risk.

We understand that, in many real estate markets, affordable properties attract multiple offers and serious competition among buyers. That is why our first recommendation is to always get preapproved for financing BEFORE you go looking for homes. Whether you are a first time buyer or an investing in a rental property, preapproval sets parameters for you to work with and raises red flags before you are tied up in a contract. That said, nobody should be afraid to use a financing condition when purchasing real estate. It affords protection and flexibility for YOU and your family.

If you are thinking of buying real estate, speak to a qualified financing specialist first so you are properly prepared to proceed. When it comes time to make an offer, make certain that a financing condition is discussed with your realtor. Consider speaking to a lawyer so you know your rights and obligations. And finally, whether or not a financing condition is included is your choice, make sure you understand the implications of the condition and contract so you understand how including a financing condition (or not including it) will affect the offer, its acceptance, and your ability to close the deal.

Only 2 Weeks Left for RRSPs – Use it Wisely

With less than 2 weeks to go to the February 29th cut-off for 2011 RRSP contributions, we thought it important to re-post a couple of entries that dealt specifically with how you use RRSP’s within your broader financial plan, and specifically, how you manage your debts.

Not everyone can or should make RRSP contributions, especially those whose financial situation is very restricted, but for those of you thinking about putting away a chunk of savings into the tax-deferred plan, here’s a couple of other things to think about besides the immediate tax benefit of making a deposit:

RRSP Loans are usually worth the cost: because of the tax benefit, low interest rate, and short repayment period, RRSP Loans are generally an affordable way to top up your savings. Be mindful of the impact of these loans on other borrowing plans, however, as they do impact your credit score and your debt service ratios. Read more about RRSP Loans HERE.

Using RRSPs as a home downpayment is a great way to save: taking advantage of the Canadian Goverment’s first-time home buyer program is a great way to increase your purchasing power and buy a home using a downpayment of tax-free dollars. There are restrictions (such as a minimum 90 day deposit history before withdrawal for closing costs) so anyone thinking about using this strategy should learn about the pro’s and con’s of the plan. Read more about using your RRSP as a downpayment HERE.

You may be better off paying down your mortgage rather than purchasing an RRSP: there are a lot of other ways to protect your savings and get ahead financially. Tax-Free Savings Accounts (TFSA’s) have smaller deposit limits but far more flexibility in terms of accessing your savings. Whole life insurance policies and Registered Educational Savings Plans (RESP’s) are other long-term savings alternatives that could be a better fit for your personal or family situation. Finally, using your cash to pay off expensive debts (mortgages in particular, but also unsecured debt or car loans) guarantees an immediate financial return (in terms of interest savings) and can put you in a better position to save (or borrow) more down the road. Watch a video about paying your mortgage instead of making an RRSP deposit HERE.

There’s a lot to consider and a lot to plan out. Don’t wait until the last minute and lock a bunch of savings in an RRSP without first determining how that action fits in with the rest of your financial plan. Speak to a qualified professional NOW (not on February 28th!) and give yourself time to make the financial decision that’s right for YOU.

What’s Your Debt Level – and Does It Matter?

As we’ve tracked the big push by banks and regulators for a tighter and tougher lending environment, we keep noting the “Debt to Income” ratio being cited as the primary driver for change. Canada’s average debt level has been widely reported as 151% of income, meaning thaton averagesomeone with an income of $100,000 has total debt (credit cards, lines of credit, car loans and mortgages) of about $151,000. An article in today’s Globe and Mail asks whether this number is actually relevant.

Why the concern? The debt to income ratio is NOT the method by which mortgage (or loan) affordability is determined. Instead, lenders calculate a debt-service ratio which allows monthly debt payments to reach 40% (or sometimes more) of your monthly gross income. This ratio recognizes that mortgages can be amortized over 25 to 30 years, credit cards require minimum payments, and so on, reducing the amount of income required to effectively manage the debt payment requirements.

Canadian banks have been talking about jacking up borrowing prices and toughening lending requirements in order to keep Canadian debt loads down, principally because these levels are approaching the 160% debt to income ratio of US borrowers just before the 2008 financial crisis and housing crash. What they neglect to note is that the debt service levels being used to approve lenders in the US were much, much higher – ” 50, 60, 70 or 100 per cent” according to the Globe. The problem, in other words, was an inflation of consumer ability to manage debt, and not necessarily the total debt held by borrowers.

What does this mean for Canadian borrowers? As the banks and other lenders tighten up, borrowing new money (or refinancing existing loans) may get tougher. Keep your credit in check and make sure you are repaying your existing debts on a regular basis; if you have shortfalls, address them with the debt-holders immediately. If you are planning on taking on more debt, use a calculator (you can find one HERE on our Calculators Page) to find out where you’re likely to end up, and speak to an experienced finance specialist who can go through the various risks and costs of what you are hoping to do.