Regulators: Concern over Growing Household Debt, HELOCs and Interest Rates

by Yvonne von Jena | November 13, 2017

Regulators are concerned that home equity lines of credit (HELOCs), which they believe was an important driver behind the expansion of household debt over the last two decades, can lead to potential macroeconomic risks when combined with increasing interest rates in the coming years. There are pockets of added risk, as well as bright spots, and regulators are signaling areas where they may intervene.

Rising Interest Rates

Let’s start with interest rates. Although the Bank of Canada held its benchmark overnight rate at 1% on October 25th after two hikes this year, rates are projected to triple in the coming years. Canada’s Parliamentary Budget Office (PBO) projects that the Bank will raise its benchmark rate to a “normal or neutral level of 3.0% by mid-2020”. In terms of the expected effective mortgage rate, the POC projects that they will increase from 2.9% in the first quarter of 2017 to 4.8% by the end of 2021. This means that Canadians will have to pay much more than they do today to service their debt in the coming years.

Higher Household Debt

Not only have debt levels risen significantly over the past two decades, but they continue grow (albeit at a slower pace of growth) and it seems it won’t be stopping, let alone reversing, any time soon. Based on the latest numbers available from Statistics Canada, household debt as a proportion of disposable income increased to 167.8% in September 2017, up from 166.6% in the first quarter. This is almost double the rate in 1990, which was 88%.  


The Growth of HELOCs

To add to regulators’ concern is a large driver of the growth in debt levels and the composition of that debt: that is, HELOCs.

First, let’s look at the growth of HELOCs in Canada. According to the Financial Consumer Agency of Canada (FCAC), the regulator that ensures federally regulated financial entities comply with consumer protection measures, “the growing popularity of HELOCs… was an important driver behind the expansion of household debt.” Here is a breakdown of the history of HELOCs as provided by the FCAC:

  • Late 1970s: The HELOC product first appeared in the Canadian marketplace
  • Mid-1990s: Lenders began tailoring HELOCs to appeal to a broader cross-section of consumers
  • 2000s: The HELOC market expanded rapidly; HELOC balances grew from approximately $35 billion in 2000 to approximately $186 billion by 2010, for an average annual growth rate of 20%
  • 2008: In the years following the recession, growth of HELOCs starts to slow
  • 2011: The government makes HELOCs ineligible for government-backed portfolio insurance, and the removal of this funding mechanism helped moderate the growth of the HELOCs
  • 2012: OSFI’s B20 Guideline was introduced, which included stricter underwriting rules and capped the loan to value (LTV) ratio for HELOCs sold by federally regulated lenders at 65%, such that between 2011 and 2013, HELOC growth slowed to 5% and it has averaged 2% over the last several years
  • 2016: Outstanding HELOC balances reached $211 billion, most HELOCs are now sold as a component of readvanceable mortgages (80% of the 3 million HELOCs were held under readvanceable mortgages), and the average balance is $70,000 

Quite concerning to regulators such as the FCAC is the flexible draw and repayment features of HELOCs, which it says “may lead many consumers to see these products as a convenient way to finance large projects…” Consider that 40% of consumers do not make regular payments toward their HELOC principal, 25% of consumers pay only the interest or make the minimum payment, and most consumers do not repay their HELOC in full until they sell their home. 

All told, the FCAC says “Regulators are concerned that higher interest rates and high household indebtedness, will lead to trouble if borrowers keep dipping into the equity of their homes and on their HELOCs without paying it back.”

The FCAC: Looking at Improving Disclosure

What can financial institutions expect in response by the FCAC? The commissioner, Lucie Tedesco, says complaints to her agency have shown people are not understanding the product. “One of the things that we will be doing with the results of our research is trying to see how we can improve the disclosure around readvanceable mortgages, and will communicate to the financial institutions our expectations on that front.”

Debt Service Capacity

Many regulators and the industry understand that what matters more for financial vulnerability is not so much the level of the debt relative to income, but rather the capacity of households to service their debt. On this account, the PBO says “household debt-servicing capacity will become stretched even further as interest rates rise to more “normal” levels over the next 5 years.”

There Is Risk, but It’s Not Across the Board

The distribution of debt is of critical importance when gauging the risk from the increase in household leverage. In a good report by Craig Alexander and Paul Jacobson on behalf of the CD Howe, which is entitled Mortgaged to the Hilt: Risks From The Distribution of Household Mortgage Debt, the authors note:

“The data suggest that the majority of Canadians have been responsible in their borrowing, but the sustained low interest rate environment has encouraged a significant minority to take on considerably more mortgage debt relative to after-tax income… it is evident that there are particular pockets of excessive leverage or risk.” 

Here are some of the “pockets” of households at elevated risk:

  • Low income earners: At the lowest income quintile, those with mortgage debt have particularly high ratios due to low income (CD Howe)
  • Urban centres: The provinces with the largest urban centres with the highest-priced real estate have experienced the most dramatic increases in mortgage debt to disposable income ratios (CD Howe)
  • Seniors: 1 in 10 households over the age of 65 had debt in excess of $100K in 2016, with lines of credit accounted for most of the increase and leaving this group exposed to interest rate increases at a time when incomes tend to fall due to retirement (RBC Economics)
  • Household under the age of 35: Between 2007 and 2017, debt-servicing costs rose for the average household under the age of 35 over the past decade as higher debt levels offset savings from lower borrowing rates (RBC Economics)

The Bright Spots

There are bright spots and mitigating factors. In a report entitled Debt Dashboard: Digging beyond the household debt headlines, RBC Economics notes, “Scorching housing activity and rising household debt have garnered a fair share of negative headlines in Canada. We acknowledge that some of the concerns are valid, especially given that households continue to take on debt and the debt to income ratio clocks in at record highs nearly every quarter. The increases have been supported by healthy labour markets and low interest rates, but the bigger risk is what happens when rates rise.”

Here are the bright spots highlighted by RBC Economics in its report:

  • Household assets exceed outstanding debt balances by a measure of nearly 6 to 1
  • Households with little or no debt: Almost one in six households (58%) have no or little debt
    • 33% of households in Canada are debt free
    • 25% owed less than $25K in 2016
  • Households with fixed mortgage rates: Many households have some insulation from increasing rates; the majority of mortgages in Canada are fixed-rate, and many households that will be refinancing in the near term will face lower rates than they are currently paying (as current 5-year posted mortgage rates are below the rates recorded 5 years ago)
  • Low mortgage delinquency rates, which are at only 0.3%
  • Strong labour market: Ongoing hiring gains are expected drive the unemployment rate modestly lower through the forecast horizon and help to contain household risks