This is a guest post by Robert, who lives in Calgary and
works as a financial advisor retired at 34. He is married, has three kids. Robert and his wife then plan to return to school and become teachers, eventually living and working overseas.
Greece is going through some very rough economic times just now. The government borrowed too much money and their interest rate is rising. As a result, the government is able to spend less money on the people and has tried to impose austerity. The people have responded by demonstrating, going on strike and rioting. It’s a sad scene, but have you wondered if your family could end up in the same trouble?
How much debt does Greece have? From 2000 to 2010, the Greek national debt rose from around 100% of GDP to 143% of GDP. This would be like a family who earns an after-tax income of $50,000 per year owing $71,500 of debt. Compared to buying a house, it doesn’t seem like a big deal. A major difference is that a house is an asset which secures the debt. The asset and the debt balance each other on the net worth statement. In Greece, debt was accumulated for consumption as well as for investment in assets. Not all of it increased the net worth of the Greek nation.
A few weeks ago, I spoke with a retired gentleman who expressed shock at the prices people are willing to pay for a house these days. When he bought a home, it cost about twice his annual income. When my parents bought a home in the early 1980s, interest rates were high and house prices were volatile. They probably paid three times their annual income for their first home. When I bought my first home (in 2004), I paid five times my annual income. Since then, house prices in Calgary have almost doubled, and my brother and sisters had a much more difficult time buying.
The housing market has put many families in a worse situation than Greece. It’s not uncommon for a family to owe debt that’s 500% of annual income, a mortgage that will take 30 or 35 or even 40 years to pay off. The reason that can work is that interest rates are so low. In the United States, though, we’ve also seen what can happen when house prices fall instead of continually rising. When the asset no longer secures the loan, there is little incentive to continue making payments to service the loan. Some people have found that it’s easier (financially) to walk away from their underwater mortgage and start over.
Besides the fact that Greece doesn’t have assets to back all of their debt, the interest rate they must pay to refinance their loans has been rising. It appears that the government, in late 2011, had to pay 18% interest to raise money and that the interest rate has now risen above 25%. This underlines the fact that the house-buying analogy was not apt. Rather, Greece is like a family with a $50,000 income who owes $71,500 in credit card debt. Even at 18%, the interest cost per year would be $12,870 or 25% of disposable income. Paying that much interest leaves little to pay down the principal, as well as paying all the bills.
Credit card debt is not sustainable. Any high-interest debt will seriously mess up a family’s finances. But even debt, such as a mortgage, that is backed by an asset could cause trouble if interest rates were to rise. Central banks in North America are predicting low interest rates for a couple years yet, which is a great opportunity to pay off debt. Because in the long term, no one wants to retire with debt.
Have you had to make tough decisions between making debt payments and paying bills? How did you deal with it? If not, how would you deal with a sudden increase in interest rates?