The debt bomb

Bank of Canada Governor Mark Carney has been saying for the past couple of years that our household debt levels are too high. Now a new CIBC study tells us exactly who is borrowing all that money.

It’s not the people you might expect — those in the 25-35 age range where family formation and the buying of a first home has historically resulted in above-average debt accumulation. No, the big-time borrowers are actually the baby boomers, notably those who are approaching retirement. They are piling on debt at an unprecedented rate, prompting CIBC World Markets Chief Economist Avery Shenfeld to label them as “punch drunk”.

The report, prepared by Dr. Shenfeld in collaboration with his colleague Benjamin Tal, found that households with the highest levels of debt were mainly the ones which are adding still more.

“Of note, the share of those over 45 among the high debt-burden group has been rising much faster than their share of the overall population,” they write. Canadians nearing retirement who should be in their prime savings years are, instead, getting themselves deeper into debt. We are already seeing an uptrend in bankruptcies for those 50 and over, but the more material impact will be that this group’s ability to spend could be severely squeezed upon retirement.”

It’s not an immediate crisis situation, the economists stress. But it raises the spectre of a large number of future retirees being financially strapped as interest rates rise and they struggle to pay the interest cost on their loans.

Last year, Royal Bank published a survey result that found that only 56 per cent of Canadians with household income over $100,000 expect to be debt-free in retirement. That’s a shocking figure, especially when you consider the income level — these are not people living on welfare. And it represents a marked change in attitude from a generation ago when carrying debt into retirement was almost unheard-of.

I regard this as one of the most important financial issues facing the boomers as they come up to retirement and I have devoted considerable space to it in my new book, Retirement’s Harsh New Realities. Following is an excerpt in which I have quantified the risk involved.

Your financial risk

Here’s an example of the financial risk you will face when interest rates move higher, as they inevitably will. Let’s assume you have a $100,000 home equity line of credit, which you have fully drawn against for renovations. These are variable rate loans, where the interest rate moves up or down to reflect any changes in prime.

Let’s say your bank was charging you prime plus one-half% interest, or 3.5 per cent. If you make no payments against the principle, the annual interest expense is $3,500. (It is actually slightly more than that because you are making monthly interest-only payments but let’s keep things simple for purposes of this illustration.)

The average prime rate in this country over the past decade is about 4.25 per cent. If the rate should move back to that level, the interest rate on your line of credit would increase to 4.75 per cent. The cost of servicing the debt would rise to $4,750 annually, a hike of 36 per cent.

But, historically, when central banks begin to raise rates they don’t stop at the average. There’s a reason they are pushing rates higher: the economy is overheating and inflation is becoming a major concern. High interest rates are intended to take some of the steam out of economy by making it more expensive to borrow money.

According to the Bank of Canada website, the prime rate was as high as 6.25 per cent in the summer and fall of 2007 as economic growth surged in the years following the 2000-02 high tech crash. We could easily see those levels again in the next few years as the world recovers from the financial shocks of 2008-09.

With prime at 6.25 per cent, the interest rate on your line of credit would be 6.75 per cent, which means it would cost you $6,750 a year to carry — and that’s in after-tax dollars. That’s almost double what you paid originally. But now you’re retired and there is no extra money coming in to cover that expense. That would put a big strain on your retirement budget. Do you have any idea where that extra money would come from?

That’s why part of your retirement plan must be directed to debt elimination. Set up a repayment program which will ensure that all your loans are paid off by the time you plan to stop work (even sooner, if at all possible).

Photo © Troels Graugaard

Gordon Pape’s new book, Retirement’s Harsh New Realities, is now on several best-seller lists. Save 50% by ordering your copy here.

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