Baby, we got a bubble!?

[interested]

I agree with your conclusions Eug with the proviso that you and I are talking about responsible people acting in a responsible manner.

We could argue priorities forever. It was not TV's or mattresses that were the issue for me; it was people taking on additional debt, increasing their carrying costs for additional discretionary items which may or may not be wise. I could have just as easily inserted vacations skiing or to the Caribbean, eating out 3x/week etc. My point was simply that while none of this is a big deal as you suggest, I hope that same person you are describing has put aside 3 months of cash flow for an unexpected car repair, house repair, or temporary/permanent job loss from current employment.

My point is: at these debt to net income ratios, there is very little room for unanticipated adverse issues that can crop up unexpectedly and very quickly tilt the marginal person with excess debt into crisis. That said, your point in your example is well taken but I point out that in the core, there is no $175K mortgage anymore as entry level will likely be $250K for 500 sq.ft. and most will not have $75K downpayments who are at this range unless they are already in the market and have benefitted from a glowing 10 year real estate increase in value (barring the 6 months or so from late 2008 to early 2009).

 

[cdr108]

Here is a concrete example. Let's take someone who makes $60000 a year, and has no debts at all. S/he decide to get a condo.

$60000 = $47807 after tax in the province of Ontario.

1.48 x $47807 = $70754.

So, using that 1.48 number as a max, the max mortgage that person could get would be $70754. Clearly that makes no sense at all.

OTOH, let's take a number like 3.5X gross salary. That would be $210000, which means a 4.4X debt to income ratio.

that's not how it's calculated according to various sources ...

How To Calculate Your Debt-Income Ratio

Your debt-to-income ratio is the percentage of your income that you owe in debt or debt payments. Most financial experts believe that you should maintain your debt-to-income ratio at 36 percent of your gross income.

Banks and other lending institutions use your debt-to-income ratio to gauge your ability to repay debt. If you have a low ratio, you have a better chance of repaying your debt. If you have a high ratio, you are considered a credit risk, which could prevent you from being approved for affordable credit.

Time to Calculate

Calculating your ideal debt-to-income ratio is not hard – simply take your monthly gross income, for example say $1,600 a month, and multiply it by 36 percent: $1,600 x .36 = $576.

Your debt payments should not surpass $576 a month. This easy to understand method will give you a better understanding as to how much of your income should be spent on paying off your debt. It also lets you know if you are overburdened by debt.

Okay, now it’s your turn. Gather several of your recent pay stubs to figure out your average monthly gross income (your gross income is your salary before any deductions are subtracted). Now gather several of your recent credit card statements and figure out the average you are paying each month. Once you have that, you will need to collect your other monthly debts, such as rent or mortgage payments, car loans, personal loans or school loans. You can leave out your household expenses such as groceries.

Once you have assembled all of this information, take your average credit card amount and add that to the total number of your other monthly debts (rent, mortgage, loans, etc.) Now divide that total number by your monthly gross income – as we did in the example above.

For your convenience, we have included our debt-income-ratio calculator so you can simply enter your data to calculate your debt-to-income ratio.

Understanding your debt-to-income ratio

36% or less: This is the ideal amount of debt for most people to carry.

37%-42%: This is okay, but start cutting your spending now before you get into deeper debt.

43%-49%: Financial distress is right around the corner unless you act quickly to prevent it.

50% or more: You need professional assistance to severely reduce your debt.

---------------

also from Wikipedia

Debt-to-income ratio

A debt-to-income ratio (often abbreviated DTI) is the percentage of a consumer's monthly gross income that goes toward paying debts. (Speaking precisely, DTIs often cover more than just debts; they can include certain taxes, fees, and insurance premiums as well. Nevertheless, the term is a set phrase that serves as a convenient, well-understood shorthand.) There are two main kinds of DTI, as discussed below.


The two main kinds of DTI are expressed as a pair using the notation x/y (for example, 28/36).

1. The first DTI, known as the front-end ratio, indicates the percentage of income that goes toward housing costs, which for renters is the rent amount and for homeowners is PITI (mortgage principal and interest, mortgage insurance premium [when applicable], hazard insurance premium, property taxes, and homeowners' association dues [when applicable]).
2. The second DTI, known as the back-end ratio, indicates the percentage of income that goes toward paying all recurring debt payments, including those covered by the first DTI, and other debts such as credit card payments, car loan payments, student loan payments, child support payments, alimony payments, and legal judgments.[1]

[edit] Example

In order to qualify for a mortgage for which the lender requires a debt-to-income ratio of 28/36:

* Yearly Gross Income = $45,000 / Divided by 12 = $3,750 per month income.
o $3,750 Monthly Income x .28 = $1,050 allowed for housing expense.
o $3,750 Monthly Income x .36 = $1,350 allowed for housing expense plus recurring debt.

 

[Eug]

cdr108,

That's the wrong debt to income ratio. What you are talking about is much more appropriate for the individual. What the article was talking about was total debt vs. yearly net income, averaged over the population at large. In fact, my whole point was that the article's number isn't relevant for talking about an individual's debt.

Remember, the number for Canada is 148%. That would be essentially impossible using the definition you are using.

 

[interested]

Thanks CDR for that clarification.
I personally think the BACK END ratio is the most appropriate since if one is carrying alot of other expenses besides the housing costs, this is extremely relevant.
So with Eug's example of $60K/12 or $5000/month x 0.36 means housing and recurring debt expenses of $1800/month. If we assume the front end ratio for just the housing that leaves: $5000 x 0.28 or $1400/month. Taking say $250 condo fees and $200 month for taxes that leaves $950 towards a mortgage/month (principal and interest). I don't know the exact amount that will get as a mortgage but based on a 5 year rate of 3.69% I am guessing that this means about $200K of mortgage. Given $500/sq.ft. x 500 sq.ft. means the individual needs a $50K downpayment or 20% which is alot if not already in the market and with equity. As well, that individual is barely qualifying if my assumption of $200K mortgage is right at the 3.69% level, let alone if interest rates rise.

The reason I believe Eug's example works is that it is premised I believe that an individual has a fair amount of equity assumed within his calculation approach by virtue of having the home equity due to having been in the market in the good times of the past decade. This will not apply to new purchasers going forward.

 

[Eug]

My point is: at these debt to net income ratios, there is very little room for unanticipated adverse issues that can crop up unexpectedly and very quickly tilt the marginal person with excess debt into crisis. That said, your point in your example is well taken but I point out that in the core, there is no $175K mortgage anymore as entry level will likely be $250K for 500 sq.ft. and most will not have $75K downpayments who are at this range unless they are already in the market and have benefitted from a glowing 10 year real estate increase in value (barring the 6 months or so from late 2008 to early 2009).

That's another reason why these debt to income ratios are irrelevant to the individual. It says nothing about savings, nor does it say anything about downpayments or anything. It's just a snapshot.

Lots of people in downtown condos have $175000 mortgages. Similarly lots of people have $30000 mortgages. Nothing in there said they mortgage had to have been taken out yesterday. It could have been taken out 15 years ago, and is nearly paid off now.

With a $60000 gross income, the take home pay is $47807. With a $175000 mortgage, the debt to income ratio is 3.7X. With a $30000 mortgage, the debt to income ratio is 0.6.

Who is in a better financial situation? One would be tempted to say the latter, but we can't really know that for sure, because perhaps the person with the $30000 mortgage is 64 years old with little retirement savings, while the person with the $175000 mortgage is 30 and is maxing out his/her RRSP every year.

So again, the debt to income ratio number 1.48X (148%) as described in the article is pretty much meaningless in itself to assess an individual's financial health. cdr108's debt service ratios are more important measures in this context.

 

[interested]

^^^
Agree fully.
I think cdr, you and I are all essentially in the same camp.
I believe as a snap shot of the overall situation of the economy, it may help give a picture but it is not meaningful to any one individual. A bit like when we say all real estate markets are local.
If one has 4x the debt to income ratio but has just entered a profession for example where one's income will rise rapidly and reasonably assuredly in the next few years, it is irrelevant. But again, as an overall snapshot, while there may be some distorted results, to totally dismiss out of hand rising debt to personal income ratios is not a prudent approach by those required to oversee the economy, i.e. Mr. Flaherty and Mr. Carney and others in positions of government.

 

[Eug]

I agree that rising debt-to-income ratios are concerning. But at the risk of sounding like a broken record, we shouldn't even be talking about this gauge for individuals at all. We should be using other gauges.

ie.

I just did the calculations myself with hard numbers for my own finances. It turns out my debt-to-income ratio is not just above 2, but it's actually closer to 3. With my spouse's income included it's still above 2.

My total debt service ratio is close to 40%, but that's because I didn't count my spouse's income. 40% is about the max, which means if my spouse lost her job I could support both of us and our mortgage payments etc. with my current income alone, but just barely. However, with both our incomes it's pretty easy.

Also, the reason my TDS is so high is because I have artificially inflated my monthly mortgage payments. I wouldn't recommend a TDS of 40% otherwise. Very tight.

BTW, when I started my mortgage, my debt-to-income ratio was closer to four. In a few years, it will be below 2. But my TDS will remain roughly the same (until the place is paid off).

 

[CN Tower]

Rate hikes could spark house price collapse, economist warns

http://www.theglobeandmail.com/repo...rice-collapse-economist-warns/article1893062/

Any move by the Bank of Canada could “easily†cause house prices to collapse, Capital Economics warns in a bleak report that suggests the Canadian housing market is likely to suffer the same sort of crash that has plagued countries such as the United States.

Any move?

 

[Eug]

http://www.theglobeandmail.com/repo...rice-collapse-economist-warns/article1893062/

Any move?

Yeah, that sounds overly pessimistic. Personally I think if rates rise by 2% in the next couple of years, prices will just plateau or decline slightly unless there are other problems with the economy. However, if rates rise by 4% (doubling 5-year fixed rates), then large price declines could occur.

To put it another way, if the 5-year fixed rate is 8% in 2014 I think the real estate market will be serious trouble. However, if it's 6%, then not so much.

 

[interested]

Extreme view for sure. The premise I believe is wrong however. The US is a fractured market. The main problematic areas have had far greater rises in prices over shorter periods of time than Canada has. The tax structure in the US favoured taking on debt to reduce your marginal tax rate. The issues have been repeated over and over so I won't go into it yet again.
I believe that a price collapse could happen but it is going to take a shock to the system for that to happen. In the US it was NINJA loans, greedy people and even a greedier Wall street, complex derivatives etc. etc.
I have not yet seen what in Canada would do this though I again repeat CNTower I am of the view that a realignment (read downward) adjustment of prices will occur (though I believe it has been once again somewhat postponed by the government giving people a potential reason to accelerate their pruchases to before March 2011 due to mortgage rule changes)

 

[Kenny]

I have a debt to income ratio much higher than 1.48, and quite frankly, I see no problem with it, assuming I understand it correctly.

You're right. There's absolutely nothing wrong with a ratio of 1.48 of debt to income. If I graduate from University with student loans totalling $60,000 and my first year's income is $40,000, I'm probably going to have no problems paying down that debt.

If you own a house that costs $400,000 (after the down payment) and you and your wife earn $200,000, you can bet that it's affordable.

The reason that the ratio is problem is that it's a national average. It means half the people have worse than 1.48 ratios. For every person who has paid off their mortgage (and there are many), there are 10 people with ratios 3.00 and up. (no, I can't back that up) If you were to look at it like a bell curve on a graph, and the top of the bell curve is 1.48, then you've got a big chunk way to the right. The top 25% indebted people are quite heavily indebted indeed.

The nature of the economy is that 5% of the people can start a cascade effect of credit problems. If 5% foreclose, then the value of houses in their neighbourhoods will decline, causing credit problems for the next 5% on the rung. More people will start renting, and there will be even fewer home buyers, causing house prices to fall and exacerbate the problem.

 

[Eug]

You're right. There's absolutely nothing wrong with a ratio of 1.48 of debt to income. If I graduate from University with student loans totalling $60,000 and my first year's income is $40,000, I'm probably going to have no problems paying down that debt.

If you own a house that costs $400,000 (after the down payment) and you and your wife earn $200,000, you can bet that it's affordable.

The reason that the ratio is problem is that it's a national average. It means half the people have worse than 1.48 ratios. For every person who has paid off their mortgage (and there are many), there are 10 people with ratios 3.00 and up. (no, I can't back that up) If you were to look at it like a bell curve on a graph, and the top of the bell curve is 1.48, then you've got a big chunk way to the right. The top 25% indebted people are quite heavily indebted indeed.

The nature of the economy is that 5% of the people can start a cascade effect of credit problems. If 5% foreclose, then the value of houses in their neighbourhoods will decline, causing credit problems for the next 5% on the rung. More people will start renting, and there will be even fewer home buyers, causing house prices to fall and exacerbate the problem.

No argument there.

I was just (repeatedly) telling people that it's a national measure, not an individual one.

 

[interested]

Agree with you Kenny.
You are referring to what economists always say is the "marginal demand or supply". Each time you eliminate someone at the margin, it propels the next individual to that position.
I think we can all agree that as a macroeconomic tool there is some validity to it. On a microeconomic scale, one might well be quite fine with a much higher than 1.48 ratio.

 

[daveto]

Agreed.

Debt-to-income ratio is useful to compare a large group with its ratio in the past. As such, our current nationwide 1.48 is troubling, when compared to the much lower ratios of 1.0 or lower 20 year ago.

Debt service-to-income ratios are more relevant on an individual basis, as it indicates an individual's ability to cover their monthly costs. Although it is only one piece of the puzzle, as assets (or a lack thereof) are an important consideration

 

[realist123]

http://www.scribd.com/doc/48120960/Canada-Economics-Focus-House-Prices-Feb-11

Economic think tank is predicting a US style collapse.