Need another reason to feel glum as you open your credit card bills after a rush of holiday spending? Here you go: If interest rates rise, so do personal insolvencies.
That’s one of the main reasons — along with record-high levels of household debt — Canadians are filing for insolvency in numbers not seen since the 2008-09 financial crisis, experts say.
“It’s fairly clear what’s going on. There’s a close correlation between interest rates and insolvencies,” said Grant Christensen, president of the Canadian Association of Insolvency and Restructuring Professionals, referring to official figures showing 102,023 Canadians had filed for insolvency in the first three quarters of 2019. That’s the biggest number in a decade.
While the Bank of Canada’s benchmark overnight rate has stood at 1.75 per cent since October 2018, it had been raised five times in the previous 15 months. Between July 2017 and October 2018, it went from 0.5 to 1.75 per cent.
“There’s a two- to three-year lag between a change in interest rates and when it impacts insolvencies. Because rates rose from 2017 to 2018, we’re seeing the impact now,” Christensen said. “It will probably start to level off some time in mid-2020.”
Still, with the Bank of Canada hinting it might consider raising rates again because the economy is “near capacity,” more insolvencies would likely follow if that happened, said André Bolduc, senior vice-president at BDO Canada, and an experienced insolvency adviser.
“If a household is living paycheque to paycheque and there’s a significant rise in interest rates, more of them will be pushed over the edge,” said Bolduc. A recent BDO report found that 50 per cent of Canadians are living paycheque to paycheque. That doesn’t leave much wiggle room for dealing with unexpected costs, including rising interest rates, Bolduc said.
“People aren’t saving. They don’t have any savings. So when there’s a crisis, they put it on credit, and they end up getting into trouble,” said Bolduc. It’s not a matter of financial illiteracy either, he said. In his own practice, clients who have filed for insolvency often understand exactly why they’re struggling.
“They usually understand what’s caused the problems. But nobody plans to lose their job, or to get divorced,” said Bolduc.
Another factor in the rising number of insolvencies is the growing number of Canadians who are self-employed, including many working in the so-called gig economy, Bolduc believes. People who used to have an employer’s payroll department taking care of the accounting are now fending for themselves, with less than ideal results.
“There are more and more self-employed people. And they might not realize all the deductions they need to make, and they can run into problems that way,” said Bolduc.
Lower-income households are particularly vulnerable to changes in interest rates, argued Matthew Sooy, a professor at Western University’s Ivey School of Business. Sooy points out that while the average household debt-to-income ratio is around 170 per cent in Canada right now, for households in the bottom fifth of earners, it’s much higher.
“In the lowest quintile, it’s more like 400 per cent. So if interest rates go up by two percentage points, that’s 8 per cent of your household income just on extra interest. It’s expensive to be poor,” said Sooy.
CIBC economists Benjamin Tal and Avery Shenfeld cautioned the Bank of Canada that raising rates much would be a mistake.
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“If raising the overnight rate to only 1.75 per cent could set off a climb in insolvencies, before any major job losses have been seen, it’s clear that taking rates to anywhere near what was historically neutral, or even where some models might currently put neutral, could prove to be overkill,” Tal and Shenfeld wrote. A “neutral” interest rate is one which is designed to keep the economy neither growing nor contracting. In April 2019, the Bank of Canada suggested the neutral rate for the Canadian economy could be as high as 3.25 per cent.
Still, Tal and Shenfeld suggested the insolvency statistics don’t mean it’s all doom and gloom. That’s because fewer people filing for insolvency these days actually end up declaring bankruptcy — many more make “consumer proposals,” a negotiated settlement with creditors which has a much less harsh effect on their credit rating.