As a result of the debt crisis in 2008, the government has since introduced new measures to tighten mortgage lending by the banks:
- Reduce the maximum amortization period to 25 years from 30 years. The maximum amortization period was reduce to 35 years (from 40 years) in 2008 and further reduced to 30 years in 2011.
- Lower the maximum amount Canadians can borrow when refinancing to 80 per cent from 85 per cent of the value of their homes.
- Fix the maximum gross debt service ratio at 39 per cent and the maximum total debt service ratio at 44 per cent.
- Limit the availability of government-backed insured mortgages to homes with a purchase price of less than $1 million.
The government has stepped in a few times in the past 5 years to curb mortgage lending but why did the lending get out of hand in the first place?
Debt advice vs debt products
There was a time when the financial industry was excellent at preaching good debt advice and the merits of paying down your debts as a strategy to achieve financial freedom and independence. That was until they discovered that debt products are not only profitable business but big profitable business!
Today actions speak louder than words. While the financial industry might talk the story of paying down debts, their actions highlight a potential conflict of interest.
- Credit card influenza. How many times do you throw away offers for new credit cards that come in the mail? There was a time when financial institutions would send you the actual credit card ready for activation but as you can well imagine, this became a real problem for some people. The government stepped in and said they cannot send the credit cards out so now they send mock credit cards and applications with the promise of being pre-approved for a nice credit limit.
- Everywhere you go. Walk through the airports and attractive representatives will smile and see if you want to apply for the BEST travel credit card. If you go to a hockey game, even NHL teams like the Oilers offer team credit cards with a FREE T-shirt or some other paraphernalia. If you go to Home Depot, Sears, Walmart or man other shops, you can get 10% off you purchase if you sign up for their credit card right at the cash register. Has this become a new revenue opportunity for these retailers?
- Mortgages are big money. How many times have banks “HELPED’ clients get into their homes by making payments more affordable. I’ve seen many times where the bank has offered to lower monthly payments by simply extending the amortization of a mortgage from 25 years to 40 years. That happened a lot until the government stepped in and said no more 40-year mortgages. It’s bad for Canadians. So then the banks suggested 35-year mortgages until the government stepped in and took those away. Now the governments stepped up once more and said no 30-year mortgages either. Total interest costs dramatically increase when amortization periods are extended which also means more interest revenue to the financial institutions.
- Leverage is risky except for the advisor. When I first came into the financial industry, it was noble to help young people start up an automatic $100 per month savings plan into a RRSP. The only problem is it’s tough for advisors to make a living from these clients because they would make $4 per month or $48 per year. What if you could turn that $4 per month commission into $1000 plus $100 per year? Welcome the world of leverage. Instead of getting the client to invest $100 per month. Get them to borrow $25,000 and invest the $25,000. Now the client uses the same $100 per month but uses it to pay the interest on the loan and now they have more money working for them in the markets. Sound good? Leverage can work for the client if the return on the investment exceeds the cost of the interest. The advisor makes money regardless of what happens to the markets or interest rates and leverage can be really lucrative for the advisor.
My five cents
Rising debts is a problem in our society and the problems are not isolated here in Canada.
The next time you get pitch into taking on more debt through debt products whether it’s a mortgage, a car lease, a line of credit, a credit card or the opportunity to leverage, ask yourself what’s in your best financial interest. What's the best debt advice for you?
It may also be prudent to ask what’s in the best interest of the bank, the retailer or the financial advisor encouraging you to go into more debt.