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Wednesday, July 27th, 2016

Why you need to pay off your debt NOW

For debtors, today’s historically low interest rates have constituted somewhat of a fool’s paradise. Central banks around the world, including Canada’s, have kept interest rates as close to zero as possible.

But if we thought we could keep our boat forever afloat on this sea of low rates, there are many lining up to convince us the time has come to get on dryer land.

Whenever they get a chance, Bank of Canada governor Mark Carney and Finance Minister Jim Flaherty warn Canadians to get their fiscal houses in order. It’s not a matter of IF interest rates start rising, just a matter of when.

And on Friday, Toronto-Dominion Bank chief economist Craig Alexander joined in, with a stern warning that debt levels have risen to “unsustainable” levels. He said without new mortgage regulations to temper borrowing, a correction in housing prices or a hike in interest rates would be “disastrous for the economy.”

“Make no mistake, such a combination of forces would likely cause a recession,” he said, grimly.

“We need to acknowledge that a significant imbalance has developed and it poses a clear and present danger to Canada’s medium-term economic outlook. If the overvaluation was fully unwound rapidly, it would be three times the correction in the early 1990s.”

The key is the connection between the overheating real estate market, which Mr. Alexander figures is between 10% and 15% overvalued nationally, and rapidly climbing household debt.

While Canadians usually think of their credit cards first whenever the Bank of Canada sounds off again on household debt, the root cause of the debt problem has been growing home purchases in an exceedingly low-interest-rate environment keeping markets attractive, he said.

One feeds into the other, leading to imbalances in both at least since the 2008 financial crisis, including a record high debt-to-income ratio of more than 150% in the past year.

As anyone who has fallen behind on credit-card payments well knows (or worse, anyone in hock to the Canada Revenue Agency), once you’re on the wrong side of compounding interest, things can fall apart rapidly. It may seem like a small burden to service debt at these low rates while you have a good-paying job, but what if you lose your position just as interest rates start climbing back to less-comfortable levels?

Even now, one-quarter of Americans aged 18 to 34 aren’t earning enough money to cover such basics as rent, food and car payments. They’re quick to reach for the plastic to tide them over but despite low interest rates for mortgages and lines of credit, ultra-low rates never came to the credit-card industry, where they remain close to 20%.

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Those who can’t make their minimum monthly credit-card payments already know the pain of high interest payments. Homeowners get off relatively lightly but the days of ultra-low mortgage rates are numbered. Many who extended themselves to get a bigger house than may have been prudent may be shocked to find how a slight rise in rates (say two percentage points) might render it unaffordable. If you’re extended even while rates are low, you should run the numbers and “stress-test” your mortgage to see how much of a rise in rates your cash flow could tolerate.

According to a Bank of Montreal survey on Thursday, two-thirds of Canadian homeowners are now locking in to fixed-rate mortgages as a way to get some “rate certainty.” Katie Archdekin, BMO’s head of mortgage products, expects rates “may change sooner than expected,” possibly as early as next year.

Half would also do the smart thing and shorten their amortization. In the early days of an amortization schedule, a huge percentage of monthly mortgage payments is made up of interest, with only a fraction paying down principal. The faster you pay down principal, the more of each mortgage payment goes to principal repayment rather than debt-servicing costs, creating a virtuous circle.

Seen thus, today’s low interest rates are actually a gift, since they provide an opportunity for debtors to pay down as much principal as possible in the early years when interest still consumes the lion’s share of payments. Once rates start rising again — my guess is in the next 18 to 36 months — it will be that much harder to do this.

Young people have been spoiled by these tremendously low rates but older Baby Boomers are well aware rates could be much higher. Our first mortgage in 1989 had a fixed rate over three years of 11.75%, and I know some who paid close to 20% in the early 1980s. Compared to those, today’s five-year fixed-rate mortgages of 3% or 10-year fixed mortgages of 4% are ludicrously low. If I were a young family starting out I wouldn’t hesitate to lock in the 10-year rate, then work hard to pay it down early.

Shorten your amortization by all means but only if you’ve first dispensed with higher-interest credit-card debt. Daniel Chometa, community outreach manager for Consolidated Credit Counselling Services of Canada, Inc., says even though credit-card rates are high enough as they are, they could go still higher in a rising-rate environment.

Andrew Barr/National Post

“Legally they’re allowed to charge up to 60%,” he says.

Some predatory lenders charge a usurious 59.9% for loans to finance the purchase of furniture and various household goods. These firms prey on bankrupts who can’t get credit elsewhere or new Canadians who think they must emulate their neighbours by filling their homes with the latest flat-screen TVs and leather sofas.

Chartered accountant David Trahair, author of Crushing Debt, suggests debtors who are in over their heads overcome their embarrassment about talking about their financial troubles and meet with a credit-counselling service. He should know, since he was once on the board of Credit Canada. “A legitimate one should give you a half-hour meeting for free, which is a great first step.”

jchevreau@nationalpost.com

Jonathan Chevreau is author of Findependence Day. Available at www.findependenceday.com.

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