Almost every Canadian farm family has four financial goals: buy a home, pay off farm and home debt, educate the kids and build up retirement savings. Satisfying all is a problem of balancing each.
Very low interest rates for the last five years have made it easier to pay off debts and buy a home, but those rates have also encouraged people to take on more debt while discouraging them from saving for the kids’ education and for their own retirement. For farmers, adding debt when interest rates are low and crop prices are high amounts to juggling two cycles.
Driven by low interest rates, people looking for income have shunned saving in the usual things such as Canada Savings Bonds, GICs and bank accounts. These just don’t pay enough. Instead, people spend on cars with what are peddled as “no interest loans” and other car deals with seven years of low payments. The cars may rust out before they are paid for. Low interest rates (some of which are not so low on plastic) have lured people into debt without forcing them to assess the risks of living on other peoples’ money.
Government, in the form of the Bank of Canada, has pushed down the cost of debt to historically low levels. Moreover, the Federal Department of Finance has made it easier to give oneself a no-interest loan. For example, you can use the Home Buyers’ Plan to take as much as $25,000 from retirement savings to use for a first time purchase of a home. The money is usually used for a down payment. Various student plans also allow tapping RRSPs. For example, students in full time training or post-secondary education and their spouses can take up to $10,000 from their RRSPs over a four-year period as long as the total amount withdrawn does not exceed $20,000. Inflation suggests that limits on that amount of money that can be transferred from RRSPs to other uses will be raised. Prime Minister Harper made an election promise to raise the Home Buyers’ Plan limit to $35,000. That’s not much more than an inflation adjustment and, given the inflated prices of homes in many communities, $35,000 is really just a drop in the bucket.
A problem of perspective
Part of the problem is perspective. Consider a house as an investment asset. Stocks may return five per cent per year based on dividends and appreciation before inflation adjustments. Corporate bonds return three per cent annually before inflation. Houses historically return four per cent per year before inflation.
The risk of price declines of an owner-occupied home, which is the largest part of the market, is moderated by the value of living in your own home. Your home pays a return in the form of rental services. There is no explicit charge, but if you figure out what it would cost to rent your house, then work out the capital value — how much money you need to invest to generate the after-tax money you need to pay the rent — the market risk of owning your own home is reduced. For example, if rent would be $1,000 a month or $12,000 a year, you would need to have $500,000 earning interest at three per cent per year before tax (based on a 20 per cent average tax rate) to leave $12,000 available for implied rent. If you pay with a mortgage, tax would be charged on what you earn to pay the interest on that mortgage. Tax would also be charged on money you earn to pay rent. It’s a level playing field.
The situation flips upside down when you want to finance your retirement. With interest rates hovering at near historic lows, the amount of money needed to generate any amount of rent or capital to generate a pension is far more than it would be if interest rates were higher. Government bonds with no risk of default pay just a few per cent a year. Add default risk in corporate bonds and you get more income. Move to stocks with still more risk and no guarantee or irrevocable promise of income and the return is still higher.
A home of your own is a low risk investment. It’s almost as solid as a government bond and, with the addition of fire and windstorm insurance, it has few uncovered risks. Given that borrowing rates are low and won’t even rise very much for years even after they begin to creep up, the cost of the mortgage offset by the implied rent you get (or don’t have to pay) when living in your own home is low.
It’s the economics
The economics of borrowing versus investing these days favour borrowing. That’s why Canadian household debt levels have soared. The total amount of credit market debt — which includes mortgages, non-mortgage loans and consumer credit — held by Canadian households hit a record high, climbing to 163 per cent of disposable income at the end of 2014. When interest rates do rise, some very indebted people, who may be those who are on the hook for retail credit on store cards for rates of 19 per cent a year, will suffer the most. Those rates can rise with 30 to 60 days notice. Fixed rate mortgages that don’t renew for a few years allow time to adjust to higher rates. Few other kinds of loans allow this much foresight of problems to come. However, coming they are. Rates must rise.
The Bank of Canada and the U.S. Federal Reserve have kept interest rates at emergency levels, even though the crisis of 2008 and 2009 is over. Interest rates on government bonds, which ultimately set the market rates for consumer loans, will eventually rise a few per cent to five per cent for a 10-year bond. But that will take years. Perhaps a decade. Until then, the market acts as though it is better to be a debtor than a lender. Sure, that is a precarious way to live, but getting rental service in the form of a house or even condo in which you live reduces the pure speculative cost of borrowing. But don’t be fooled. The risk of debt never goes away.
Folks who already own their homes should not remortgage just to take advantage of ultra low interest rates. Some investment dealers encourage borrowing against equity, which is foolish when you examine the risks involved. It’s a bad move because whatever investment one makes in a capital market other than a short government bond, which pays almost nothing, has much more risk than living in a paid up home of your own.
Moreover, as one ages, the time for recovery for losses diminishes. A common pitch for the “hock the house” strategy is that stocks or one sort or another have outperformed houses during some sample period. The investment advisor picks the sample period to make his example work, talks up the money to be made, then uses the old line about stock markets never falling over periods of 10 years. The advisor may even throw in a costly investment guarantee, sold by insurance companies, that a portfolio of funds held for ten years can be set up to refund 80 or 100 per cent of purchase value. If you need a reply to all this, one word should do it: Nortel — Canada’s telecom giant that filed for bankruptcy in 2009.