Could the Stress Test Exacerbate the Credit Card Problem?

Mortgage debt has been in the crosshairs of federal regulators for years.

But considerably less attention has been paid recently to unsecured debt—i.e. credit card—balances for which have been growing at an alarming pace.

And with the 2016/2018 mortgage stress tests crimping the amount homeowners can borrow at low rates, it’s likely that even more Canadians will be forced to rely on credit cards for financing.

“The utilization of credit cards has been trending higher and gaining momentum,” Bill Johnston, Equifax Canada Co.’s VP Data & Analytics, confirmed in a recent release.

Millennials Leading the Trend

Research shows Canadians aged 22 to 37 with credit cards saw their average card debt increase 6.9% to $11,716 in 2018. Compare that to the average mortgage, which grew just 3.1% in the same timeframe.

Adding fuel to the fire is the fact that 31% of millennials are saddled with student loans (as of 2017). It’s no wonder so many are increasingly relying on credit cards.

“As they become older, we…see a rise in the use of credit card debt and lines of credit among millennial debtors,” said Doug Hoyes, a licensed insolvency trustee and co-founder of Hoyes, Michalos & Associates Inc. “What concerns me is that this is debt that is used to pay for everyday living costs like groceries, transportation and other personal living expenses. They view their minimum payments as just another monthly budget expense to be covered, often through the accumulation of more debt.”

And a mortgage refinance won’t save most young debtors. For one thing, most haven’t had time to build significant equity. Moreover, the stress test has made it far tougher to consolidate debt at low rates. And more to the point, millennials over their head in debt don’t generally own homes. Only ~3% of all millennial debtors owned a home at the time they filed for bankruptcy, according to Hoyes.

A Growing Concern

Considering that interest rates on credit cards average around 19% and run up to 29%, they’re one of the most expensive forms of debt available. And the consequences are starting to materialize.

We don’t have this data for Canada, but in the U.S. 60% of credit card borrowers between the ages of 18 and 34 carry sizable balances, pay late fees or engage in other costly credit card behaviours, according to figures from the Financial Industry Regulatory Authority Foundation.

One in 12 of millennials’ credit card balances were seriously delinquent in the first quarter of this year—the highest percentage for any age group, according to the New York Federal Reserve Bank.

Warning signs are also appearing on this side of the border. In June, DBRS Ltd. Released Q1 data showing a decline in the average credit card payment rate to 41.9% from 46.9% in Q4 2018 (partly due to calendar effects, but still down compared to last year).

“A lower payment rate indicates that more borrowers are revolving their credit card balances, which typically results in higher finance charges,” the report notes.

Policy-makers are starting to take heed. This summer, Quebec introduced new rules that will effectively force credit card customers with balances to pay down their debts faster, and with less interest. Banks must now make borrowers pay at least 2% of their outstanding balance each month, with that amount increasing to 2.5% next year and 5% by 2025. All QC new credit card agreements already have the 5% minimum payment in effect.

Side Note: Other provinces are expected to follow Quebec’s lead at some point. This will make it harder for borrowers carrying credit card balances to qualify for a mortgage. Reason being, lenders presently use 3% of a card balance when calculating a mortgage applicant’s “debt service ratio.” A 5% minimum payment will push up total debt service ratios, increasing the chances borrowers exceed lender limits.

For some, such measures could end up exacerbating the situation by pushing over-indebted borrowers towards expensive unsecured loans and high-cost card juggling (using cash advances on one card to pay another, card surfing, balance transfers, etc.).

The Stress Test Effect

Higher minimum payments may not reverse Canadians’ growing dependence on high-cost borrowing. Nor will OSFI’s Guideline B-20, which includes the infamous mortgage stress test. Among other things, the rule changes made it more difficult for those wanting to refinance an existing mortgage.

Refinancing is a common strategy for those needing to consolidate higher-interest debt. The problem is, B-20 inflates borrower debt ratios artificially by mandating a 200+ basis point higher rate for mortgage payment calculations. That puts low-cost refinancing effectively out of reach for as many as 1 in 7 homeowners. In most cases, those needing to refinance have debt ratios above the new limits.

With debt consolidation no longer an option for those individuals, it means they are likely to stay in debt longer, instead relying on higher-cost non-prime mortgages, private lenders, high-interest credit cards, loans and unsecured credit lines.

In fact, regulatory measures designed to reduce indebtedness often just push debtors to higher-cost forms of debt. Regulators don’t seem to understand that most debt is involuntary (due to income loss, business failure, divorce, death of a spouse, illness, etc.) or chronic/habitual (a psychological need to spend). Once most debtors get on the hamster wheel of borrowing, they don’t stop spinning until they’re able to refinance, increase income, receive a windfall or go insolvent.