Last week I wrote about why our debt to income ratio is a misleading statistic when you break it down to the individual level.
While Canada’s 164% debt to income ratio is alarming at the macro level, it’s not as meaningful to the average Canadian who’s carrying low interest mortgage debt.
A number of bloggers disagreed with my assessment (here, here and here), arguing that more Canadians should be worried because our debt to income levels are close to the 170% household debt to income levels hit by Americans at the peak of their housing bubble in 2007.
When you carry a lot of debt you’re also exposed to increased risk if you lose your job or if interest rates rise quickly.
I understand where they’re coming from, but I still maintain my view that debt to income is not the right yard stick to measure our financial health.
Apples and Oranges
First, it doesn’t take your assets into account. In a low interest rate environment many people choose to invest their money rather than pay off debt.
If interest rates were to rise dramatically, or you lose your job, you’d sell off your assets to pay down debt or to cover your expenses for a few months.
Second, it doesn’t make sense to compare one year’s net income with mortgage debt that’s amortized over 25 years.
CIBC economist Benjamin Taal agrees when he says you’re comparing apples and oranges when you lump in long-term debt with short-term debt. ”You can’t compare what you owe for 25 years to your annual income,” he says.
Taal goes on to say that, on average, Canadian households pay about 7.6% of their after-tax income on interest payments. That number was 8.8% in 2000 and consumers were able to handle the load.
Net Worth by Age
Final point and I’ll let this go. We’d all like to see how our finances stack up to our peers or to the average household. Comparisons can be good if they keep you motivated and give you something to strive towards. But using the wrong metric isn’t very helpful.
Consider another useless metric – this one from Thomas Stanley’s, The Millionaire Next Door. The author defines an average accumulator of wealth as having a net worth equal to one-tenth their age multiplied by their current annual income from all sources.
That means a 25-year old who earns $50,000 a year should have an expected net worth of $125,000. An under accumulator of wealth would have half that amount, and a prodigious accumulator of wealth would have twice that amount.
I don’t know a lot of 25-year old’s with a positive net worth, let alone $125,000 or even $62,500. I won’t reach ‘average accumulator of wealth’ status until I’m 35.
Here are some more great personal finance articles for you to enjoy this weekend:
- Preet Banerjee released his latest mostly money, mostly Canadian podcast
- The Big Picture asks what are you lying to yourself about?
- Timeless Finance is ditching the spousal RRSP
- Bible Money Matters explains how to save money on just about everything
- Canadian Finance Blog looks at challenging your property assessment
- Young and Thrifty explains why you need to get a home inspection
- My Own Advisor wonders if price matching is worth it
- My University Money says why be a grunt when skilled labour is calling?
- Retire Happy Blog explains how much you’ll get from CPP in retirement
- She Thinks I’m Cheap explains how employee share purchase plans work
- Million Dollar Journey shows how to calculate annual returns using XIRR
- Canadian Couch Potato is offering a unique for DIY index investors
Have a great weekend, everyone!