Will the housing bubble lead to more bankruptcies?Pascal Gagnon
Are we currently experiencing a housing bubble? Should we expect house prices to collapse in the near future? If so, what will the consequences be?
As a Licensed Insolvency Trustee (LIT), I am not in the best position to discuss the first two questions. My field of expertise is insolvency, i.e. consumer indebtedness.
I can comment, however, on the likely financial implications resulting from property depreciation.
This is especially true since there is a link between rising property values and increased levels of debt held by Canadian households.
Insolvency rate is dropping
The average level of debt held by Canadians has reached a historic high of 167.3%. However, statistics from the Office of the Superintendent of Bankruptcy Canada (OSB) show that the number cases of insolvency in Quebec and Ontario is declining.
How could it be possible that people are more indebted but less insolvent?
Part of the answer may be hidden in the popularity of home equity lines of credit. This is a key variable linking rising property values and the level of debt held by Canadian households.
Explosion in the number of lines of credit with a mortgage
Unsurprisingly, mortgages represent the largest percentage of debt of Canadian households: 77%. However, many will be surprised to learn that lines of credit represent 48% of all other debts.
The growing popularity of this product has led the Financial Consumer Agency of Canada (FCAC) to conduct a study on the phenomenon.
The FCAC report notably shows a direct correlation between the use of home equity lines of credit and increase in the level of indebtedness of Canadians. Both data points have had a virtually identical progression over the past 15 years.
The report also indicates that:
- the average outstanding balance on these lines of credit is $70,000;
- 4 out of 10 consumers do not make regular payments to reduce their balance; and
- 1 out of 4 consumers pay only the interest or the minimum payment.
The role of the housing bubble in consumer debt
Housing bubble or not, the average property value of homes has been rising since the year 2000. Curiously, the growing popularity of home equity lines of credit also coincides with this period. Are you starting to see the connection?
Here’s a simple overview of what happens.
- The home equity line of credit limit is set at a maximum of 65% of the purchase price or market value of a house.
- For various reasons, including a housing bubble (or not), the market increases the market value of a house.
- Therefore, rising property value has a direct impact on the ability of consumers to borrow money, because higher value means larger lines of credit.
- Consumers use their line of credit, thereby increasing their level of debt.
The FCAC describes the phenomenon as follows in its report:
“Consumers borrowed against their home equity to consolidate debt, finance home renovations, fund vacations and purchase big-ticket items such as cars, rental properties, cottages and financial assets (e.g., securities), using leveraged investment strategies.”
This could explain in part why many indebted consumers still manage to honor their financial obligations.
But aren’t consumers who use this strategy only buying time?
The risks faced by indebted consumers
Using your line of credit as a source of income has its dangers.
1. Increased interest rates
Lines of credit are generally linked to variable interest rates. The historically low rates that we have experienced have probably encouraged people to use their line of credit as a backup.
But the Bank of Canada has finally raised its policy interest rate by 0.25% in July, and economists agree that it will rise further.
For this reason, lines of credit will likely charge higher interest fees.
Consumers who are already walking a financial tightrope will struggle even more if interest rates continue to climb.
2. High balance on a line of credit
When the balance on your line of credit is high, higher interest fees are charged.
But another problem that is often ignored is the loss of profit on the sale of a house.
For example, consider a couple going through a divorce. Being co-owners of the house, they agree to sell it.
- The balance of their mortgage is $220,000.
- The balance of their home equity line of credit is $70,000.
- They get an offer of $300,000.
- After paying off their joint debts, they will only receive about $5,000 each.
3. Depreciation of property value
We all know the old saying: what goes up must come down.
This applies to property values in a housing bubble. So homeowners, whose houses have undergone artificially inflated value, beware. Increasing your line of credit to maintain your lifestyle may cause financial problems in the future.
If the value of houses is expected to come down, or even stabilize, it will become impossible to rely on the same strategy. Once the line of credit limit has been reached, it cannot be increased further.
Another way to make ends meet is needed.
Each risk on its own is enough to cause someone severe financial difficulties. Imagine the consequences if several of these occur at once. Ultimately, declaring bankruptcy or filing a consumer proposal may be unavoidable in some cases.
Adopting a proactive approach
If you live in a region affected by a housing bubble and/or if the balance of your line of credit has you worried, act now.
Review your budget and come up with a plan to repay your line of credit. Take advantage of the fact that interest rates are still low to repay more capital. You’ll lower your balance and pay less interest when rates rise.
If your level of debt is stressing you out and you feel trapped, remember that you aren’t alone. Each year, approximately 4,500 consumers consult with Ginsberg Gingras for advice and solutions to their debt. Follow their lead: contact us, it’s toll-free and completely confidential.