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Thursday, March 30, 2017

Unsustainable debt

Posted by Robert on February 13, 2012

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?


3 Responses to “Unsustainable debt”
  1. deegee says:

    I guess I don’t understand why someone would walk away from a house because its mortgage’s principal balance exceeds its current market value.

    One buys a house to live in for a long time and knows how much the monthly payment will be when he buys the house (adjustable-rate mortgages not withstanding). If its value happens to drop along the way, that doesn’t change the monthly payment or make the house any less liveable.

    I bought my apatrmment in 1989 when interest rates were high, as were housing prices. By the early 1990s, housing prices had fallen a lot, as had interest rates. I had a 5-year ARM so I refinanced the loan and dropped the monthly payment by nearly 40%. But I was for a few years underwater, as apartment prices had fallen greatly, too. While that bothered me a little, I had no plans to sell the place so the decline in what I *could* get for my place had no real impact on my life.

    By the end of the 1990s, the housing market had rebounded and in the 2000s it kept rising. Even today, despite some residual declines I could still get more than what I paid in 1989. But I have no plans on moving, as this is where I live, so any unrealized gain means about as much to me now as any unrealized loss did in the early 1990s.

    Meanwhile, after taking advantage of the low interest rates in the early 1990s, I paid off the mortgage in 1998, becoming debt-free, and making a big first step towards early retiring in 2008 at age 45.

  2. Sarah says:

    Everyone should do a search for videos and articles by Ann Pettifor. I have learned many things from her, including the correction of a mistake that everyone makes:
    Debts are not paid for on the whole by selling home and hearth; they are paid out of income. When wages fall and jobs are lost, the income for repayment dries up. This is different from loans to a country: Since the time of the Milner Group in the 1800’s, they looked at national loans as being secured by the nations’ taxes.

  3. Robert says:

    Sarah, you’re right that debt is paid from income and also that nations’ creditworthiness is based on their ability to collect taxes. That’s why it’s possible for both families and nations to get into trouble when interest rates rise or income falls. Although a small amount of debt is acceptable and will help a family (or nation) get ahead if properly invested, more debt leads to more risk.

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