"Households with elevated levels of debt are more vulnerable to increases in interest rates", the Canada Mortgage and Housing Corporation redundantly observes in its latest bulletin and warns that "with interest rates on the rise, highly indebted households could see their increased required payments exceed their budgets."

Naturally, this increased debt payment burden usually come at the cost of reduced consumption, decreased savings or opting to make lower repayments on principal amounts. Some households might even default on their loans if their incomes are not sufficient to cover higher expenses and credit charges.

And, as the CMHC ominously warns, if an increasing number of borrowers begin to default on their loans, financial institutions may decrease lending activities in response.

These negative effects could then impact other areas of the economy. Research has shown that recessions in highly indebted countries tend to exhibit a greater loss in output, higher unemployment, and last longer compared to countries with lower debt levels.

Here are some of the latest troubling observations on Canadian household debt levels from the CMHC:

Household debt to disposable income near record levels

The debt-to-income (DTI) ratio is a measure of the relative vulnerability of indebted households. While households may be able to service their debt during periods of low interest rates, some may face challenges when rates rise. Highly indebted households have usually few debt consolidation options to respond to increasing debt service costs.

Total household debt relative to disposable income has been trending higher as indebtedness has been rising faster than incomes, with mortgage debt being a major contributor, counting for two-thirds of all outstanding household debt in Canada. While the increasing trend in the Canadian DTI ratio has now paused, it remains near a record high, hovering around 170% in Canada and varies significantly among Canada’s metropolitan areas (see chart 1). Vancouver and Toronto have the highest DTI ratios in the nation, at 242% and 208%, respectively. Thus, the DTI ratio in Vancouver is more than double the level in Saint John (106%).

While the DTI ratio in Canada has not changed much over the last 9 quarters, that is not the case for all centres. Significant year-over-year percentage point changes have occurred in Edmonton (-8.3), Calgary (-7.9), Hamilton (5.9) and Victoria (4.2). The drops in Calgary’s and Edmonton’s DTI ratios were driven by income growth, as total debt levels only decreased slightly. For Hamilton and Victoria, DTI ratios increased as a result of strong growth in mortgage debt and installment loans.

Chart 1. DTI ratios are highest in Vancouver and Toronto

Sources: Equifax, Statistics Canada, Conference Board of Canada, CMHC calculations

Servicing costs of mortgage debt relatively constant

Even though mortgage debt has risen, the share of household income needed to service mortgage debt has not varied dramatically over the last several years. The increasing share of income that goes to repayment of the principal represents equity accumulation, while the share that goes to interest is the cost of credit. The total cost of mortgage payments relative to total disposable income has hovered around the 6% mark for the past 10 years. The interest portion of household mortgage payments has, for the most part, been trending lower for about 25 years (see chart 2).

Chart 2. Principal repayment share has been increasing

Source: Statistics Canada Table 11-10-0065-01

Household debt composition determines sensitivity to interest rate changes

The composition of debt influences how quickly changing interest rates impact households. Line of credit loans and mortgages with variable interest rates would be the first to feel the impact of higher interest rates. Consumers holding existing credit products with fixed interest rates, such as auto loans, would not be affected at all on these items. Given that three quarters of mortgages have fixed rate terms, rising rates would not impact these loans until renewal. A rise in the mortgage rate would impact about half of all mortgage loans within the first year following an increase.

The effect on household finances following a hike in interest rates is a function of how quickly debt service charges increase. Analysis of debt composition by metropolitan area provides comparisons on how quickly various shares of household debt are impacted by a change in interest rates. Segmenting the DTI ratio by debt product provides the share of each product’s debt burden relative to income.

Vancouver households have a 177% mortgage debt-to-income ratio and a 31% HELOC debt-to-income ratio. Thus the debt-to-income ratio tied to real estate in Vancouver is approximately 208%, more than 3 times the ratio in Saint John. Toronto has the second highest DTI ratios for mortgages and HELOCs, at 145% and 25%, respectively. For all of Canada, the DTI ratio secured by real estate is approximately 133% (see chart 3).

It is interesting to note that the DTI ratio not secured by real estate is highest in Halifax at 47%, with DTI ratios of 20% for installment loans, 10% for credit cards, 9% for LOCs, and 8% for auto loans. At 30%, Victoria has the lowest DTI ratio not secured by real estate compared to the national average (39%).

Chart 3. Mortgages are the main contributor to the total debt burden

Sources: Equifax, Statistics Canada, Conference Board of Canada, CMHC calculations