Low interest rates are luring us into borrowing with equity loans

Catherine and her husband tapped into their first home equity line of credit 15 years ago to borrow $15,000 to buy a car at low interest rates.

A few years later they needed another car so the bank raised the loan to $70,000.
Then Catherine unexpectedly lost her job and it took her over a year to get another job with much lower pay.

Now the line of credit is just around the maximum level.

“We try to put in $1,000 per month to pay it down and we just end up taking it right back out. The money is just too accessible.”

Catherine would like to boost their line of credit by another $40,000, use that to pay for another kitchen she badly wants and then repackage all of their debts into a mortgage, which they would eliminate though structured monthly payments.”

Their story is a common one. Lured by very low interest rates, Canadians are taking on record debt.

A recent Statistics Canada report showed that household debt rose to a new high in the second quarter of 2011, surpassing U.S. levels.

TransUnion credit bureau states that the average Canadian has more than $25,000 in consumer debt including credit cards, lines of credit, student debt and car loans but excluding mortgages. The bulk of it is from lines of credit with low interest rates.

Consumer spending accounts for 64% of our economy.

People sometimes take out a line of credit to pay down more expensive credit card debt. You then lose track of the increased loan amount you owe and the credit card spending levels start to creep back up.

Lines of credit balances have increased 95 fold since 1985, compared to incomes and economic output having increased only 3 times. Some of this has gone into investments but a lot has gone into financing second cars, vacations and other non- appreciating goods.

You should ask yourself the following questions:

  • How much debt do you have? 
  • Will you be debt free at retirement? Take your total family debt and divide it by the years to retirement. Say it is $200,000 and you want to retire in 10 years. Can you handle repaying an average of $20,000 per year compared to your family after tax income?
  • What is the ratio of debt to your family income? The average Canadian household has a debt-to-personal disposable income ratio of 151%. Calculate this by your total family debt divided by your family’s annual after tax income. If you are below this level, you are in a better position.
  • What type of debt is it? If most of your debt is consumer debt (credit cards, lines of credit) to buy consumer debt, this is more risky that mortgage debt to buy the home you live in.
  • What interest rate will you pay? Credit card debt is especially high. If you are going to add debt, obviously it is better to add lower interest type of debt.
  • Will a fixed-rate mortgage protect me? Many people have mortgages and lines of credit at variable interest rates tied to the prime rate, which is currently 3%. When the interest rates rise (likely we are told, starting in 2012), the resulting increased monthly payments may be too much for many to handle.