August 17, 2022

Rising interest rates and household debt: Are Canadians at higher risk?

Interest rates are on the rise in Canada and around the world as central banks scramble to stem the fastest inflation we’ve seen in a generation.

Raising interest rates is the most important policy action that central banks can take to combat inflation. Making borrowing more expensive helps to slow demand, easing imbalances with supply, and thus tempering price inflation.

The challenge is that higher interest rates also mean higher debt servicing costs. And Canadians in general carry a lot of debt. Payments on mortgages, credit cards and other loans are going up, leaving less money to spend on essentials.

Is this equally true elsewhere? Or is this a uniquely Canadian problem? In this Quick Read, we compare household debt in Canada with other countries, explain why Canada stands out, and discuss why that matters in a higher interest rate environment.

Canada vs. other countries

For international comparisons especially, a common way to measure household debt is by expressing debt as a percentage of disposable income. Disposable income refers to take-home pay after taxes and after government transfer payments like the Canada Child Benefit and GST rebates.

The findings are stark. Canadian households are easily the most indebted in the G7 and among the most in the entire OECD. In 2020—the most recent year for which data are available for all countries—household debt in Canada was equivalent to 177.3% of disposable income. By comparison, the next highest G7 country was the UK at 147.7%. Meanwhile, household debt in the US was about 101% of disposable income, and it was below 100% in Germany and Italy.

Within the broader 38-member OECD, Canada ranks ninth in terms of average household debt. Denmark and Norway sit at the top of the list, at close to 250%. At the other end of the spectrum, debt levels in Mexico are just 24% of household disposable income.

Historical trends

Household debt in Canada is significantly higher today than it was a generation ago. In the late 1990s, debt was equivalent to about 117% of disposable income. However, borrowing soared over the next two decades, and household debt reached 186.6% by 2016.

The good news is that debt levels have remained more or less unchanged over the last five years. The only exception was 2020 when the debt-to-disposable income ratio dropped temporarily, driven largely by CERB payments and other COVID relief. However, by 2021 debt had returned to pre-COVID levels—185.6% of household disposable income. 

Why are Canadians so in debt compared to people in other countries?

Simply put, the answer to this question is housing prices. When measured against incomes, Canada has the most expensive housing market in the entire OECD.

As housing prices rose in the 2000s, Canadians needed to take on larger and larger mortgages to buy a home. With non-mortgage debt increasing much more slowly, mortgages are growing to dominate households’ debt profile. Back in 2005, mortgages accounted for about 62% of all household debt in Canada. By last year, that had risen to 74%.

By contrast, non-mortgage loans have been flat or falling in recent years. Since 2020, households used some of their CERB payments and other income supports to pay down their credit cards and other loans. As of May 2022, non-mortgage household debt in Canada is 4.2% below pre-COVID levels. Considering the decades-long unbroken streak of rising non-mortgage debt in Canada prior to 2020, that’s a remarkable turn of events.

What does all this mean in practical terms?

In spite of this recent improvement on the non-mortgage side, Canadian households remain highly indebted, which means they spend a significant share of their disposable income making required payments on their mortgages and credit cards. As of the most recent data (Q1 2022), Canadians spent an average of 13.5 cents of every dollar paying interest on their existing debt.

But that’s about to change. With inflation both more extreme and more persistent than initially expected, the Bank of Canada is raising interest rates at a rapid pace to try to keep price growth in check. Since January, the central bank has raised its key policy rate from 0.25% to 2.5%, including a 1.0% increase in July—the largest single hike in 24 years. More increases are likely to come before year-end. 

The policy goal is to bring inflation back to the 2% range without triggering a recession in the process. That’s a tough balancing act for the Bank of Canada. Households here are much more indebted than in most other countries, meaning they are more sensitive to each rate increase. That makes the risk of tipping into recession much greater. And for households already struggling with inflation, the cure can look just as bad as the disease.

Mike Holden, Vice President of Policy & Chief Economist

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