Thinking of taking on more debt? How to DIY your own financial stress test

With interest rates at near-zero levels, the temptation to borrow is growing.

The first wave of pandemic restrictions and job losses triggered a national savings spree. Canadians rushed to beef up their emergency funds, and many also found they had more cash on hand at the end of the month with COVID-19 restrictions trimming both their commuting costs and their spending on dinners out and entertainment.

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Government aid programs tied to the health emergency also helped keep debt loads in check by propping up incomes. As of Statistics Canada’s latest tally, Canadians owed $1.71 for every dollar of household after-tax income, down from $1.81 at the end of 2019.

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But as the economic crisis triggered by the pandemic drags on and interest rates remain low, worries are growing that the ability to borrow for cheap will once again drive up household debt. The Bank of Canada said on Wednesday it doesn’t foresee inflation “sustainably” returning to above its two per cent target until 2023, which has economists forecasting its trend-setting policy interest rate will remain on hold at record lows until at least late 2022.

Canadians shopping for a mortgage or home-equity line of credit (HELOC) “should expect fixed and variable rates to remain at their current historic lows until 2023,” said James Laird, co-founder of Ratehub.ca and president of CanWise Financial mortgage brokerage.

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Beyond the housing market, while some are resorting to debt to make ends meet, others seem to view low interest rates as an opportunity. A recent survey for consulting firm MNP, for example, found that while more than 40 per cent of respondents say they weren’t confident they would be able to cover their living expenses for the next year without going further into debt, around 60 per cent thought now would be a good time to buy things they otherwise might not be able to afford.

The risk is some borrowers won’t be able to keep up when interest rates rise.

“Low interest rates may be providing unwarranted comfort,” Grant Bazian, president of MNP’s debt consultancy practice, said in a statement. “Some risk being lulled into a false sense of security that will put them in a debt trap.”

That may be less of a concern for mortgage borrowers. The mandatory financial stress test administered by federally regulated lenders ensures qualifying borrowers would be able to cover debt payment even if interest rates increased. Nothing like that, though, exists for non-mortgage debt.

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But if you’re thinking about taking advantage of the extra-low interest rates and wondering whether you can truly afford to take on more debt, you can run your finances through your own DIY stress test.

Here’s what the test may look like, according to insights provided by Bazian and Scott Hannah, president and CEO of the Credit Counselling Society.

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Step 1: You need a budget

The very first step is to make a budget, if you don’t already have one, both Bazian and Hannah said. You need a firm handle on what money is coming in and going out every month before you can assess whether you should apply for a new loan or more credit.

There are plenty of online tools to help you sort out your inflows and outflows, including worksheets you can download for free and apps that help you track your spending and save up for upcoming and unexpected expenses.

Bazian recommends being conservative with your budget. On the income side, leave out bonuses, sales commissions and overtime, he says. And when looking at expenses, round up the numbers to build a bit of “cushion,” he adds.

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Step 2: You need emergency savings

Just because you have some spare capacity in your budget, doesn’t mean you should use it up to borrow.

While any budget should include room for savings, ask yourself whether you have an emergency fund and whether it’s adequately funded.

If the answer is no, “you shouldn’t be considering taking on additional debt,” Hannah says.

He recommends having between three and six months’ worth of living expenses squirrelled away for major financial curveballs like a job loss. That may seem like a lot, but Hannah notes you’ll likely be able to cut down your spending significantly in an emergency, so the amount you need to save is considerably less than three to six times your after-tax income.

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Step 3: Keep your debt payments to 20 per cent of your after-tax income

Once you have a budget and a big enough rainy-day fund, take a look at your debt. How much much of your monthly income is going to credit card and loan payments?

“We’ve always advised consumers that there should never be spending more than 20 per cent of their take-home income on debt servicing, excluding mortgages,” Hannah says.

If you’re pondering taking on new debt, you’ll want to make sure you’re still within that 20 per cent threshold, he adds. You should also account for any added expenses that may come with new purchases, Hannah warns. For example, the cost of a new car goes well beyond the monthly auto loan payments to include insurance, gas, maintenance and repairs.

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Step 4: What else is coming up?

Before you give yourself permission to borrow, you should also think about the future: are there any major expenses coming down the pike?

If you’ll be helping to bankroll your kid’s wedding, for example, you may want to hold off on extra debt, Hannah says.

And more immediate concern for many Canadians is tax debt, Bazian said. The federal government has been withholding no or very little tax on the Canada Emergency Response Benefit (CERB) and other COVID-19 aid, so many taxpayers will face a larger-than-usual bill this tax season, he warns.

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Step 5: What happens if interest rates go up?

Finally, run your budget through a scenario in which interest rates go up, Bazian says.

Rates may rise by half or three-quarters of a percentage point in 2023, CIBC chief economist Avery Shenfeld told Global News via email.

“Looking further out, expect a return to where interest rates were back in 2019, before we took a hit from Covid,” he added.

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If you have debt that carries a variable interest rate, such as a variable-rate mortgage or a line of credit, you may see an increase in either your repayment amounts or the time it will take you to pay off your liabilities. If you have a fixed-rate mortgage, keep in mind you may have to renew your loan at higher rates. And you may see even your car payments climb. Some auto loans are interest-free for the first couple of years, but the lender starts to charge interest set at market rates, according to Hannah.

If you can’t keep up, an increase in one of your debt payments can trigger a domino effect, if it causes you to miss or be late on other repayments, he warns. Lenders will charge you with penalties or additional interest that can quickly add to your debt-servicing costs, he says.