The Bank of Canada is preventing you from getting debt relief

The actions of the Bank of Canada in slashing its key interest rate since the 2008 financial crisis has created a large number of individual debtors who are desperately seeking […]

The actions of the Bank of Canada in slashing its key interest rate since the 2008 financial crisis has created a large number of individual debtors who are desperately seeking debt relief but are unable to do so because of real estate asset inflation. I have consulted with many debtors over the past few years who have become “house rich” but “cash poor”.

To illustrate this, I recently had a consultation meeting with a young lady (let’s call her “Jaci”, not her real name) who desperately needed relief from her debts. Here was her situation:

  • Jaci was a self-employed marketing consultant who barely earned enough to pay for her living expenses and the minimum payments on her debts, which consisted of about $100,000 in credit card debt. For the last 8 years, she’s only been able to pay the interest on her debt, which has been stuck at this $100,000 balance for the past 8 years.

 

  • She recently got engaged and wanted to deal with her debt before getting married. She didn’t want to burden her new spouse with her financial baggage.

 

  • Jaci lived in Toronto and was renting an apartment. However, she was originally from Ottawa and owned a one-bedroom condominium in that city, which she was renting out. The rent she received was just enough to pay for that property’s carry costs, which consisted of interest payments on her home equity line of credit (“HELOC”), property tax and maintenance fee payments, but there was no money left over for herself after covering her condo’s carrying costs. She has also owned this condominium for the last 8 years.

She had considered meeting with a bankruptcy trustee 8 years ago – here was her financial situation back then:

JACI’S NET WORTH – JULY 2007

ASSETS

Condo in Ottawa – value of $200,000

DEBTS

Credit card debt – $100,000

Condo HELOC – $170,000

NET WORTH

$200,000 – $100,000 – $170,000 = ($70,000)

Note: the Bank of Canada’s key interest rate in July 2007 was 4.5%

And her was Jaci’s financial situation when I recently met with her:

JACI’S NET WORTH – APRIL 2015

ASSETS

Condo in Ottawa – value of $300,000

DEBTS

Credit card debt – $100,000

Condo HELOC – $170,000

NET WORTH

$300,000 – $100,000 – $170,000 = $30,000

Note: the Bank of Canada’s interest rate in April 2015 was 0.75%

Jaci’s debts were identical in both situations, but the value of her Ottawa condo significantly increased between July 2007 ($200,000) and April 2015 ($300,000) due to the Bank of Canada significantly decreasing its interest rate from 4.5% to 0.75% during this same period.

Jaci was insolvent in July 2007. That is, the amount owing on her debts exceeded the value of her assets by $70,000. Another way of stating this is that Jaci had a negative net worth of $70,000 – if Jaci sold her condo and used the sale proceeds to pay her debts, she would still be owing $70,000. In this situation, Jaci would have been eligible to file a proceeding under the Bankruptcy Act with the assistance of a bankruptcy trustee (for example, a consumer proposal). A debtor can only file a proceeding under the Bankruptcy Act if she is insolvent.

However, in April 2015, Jaci had a net worth of $30,000. That is, the value of her assets exceeded the amount owing on her debts by $30,000 – if Jaci sold her condo and used the sale proceeds to pay her debts, she would still have $30,000 in her pocket after paying her debts in full. In this situation, Jaci was not eligible to file a proceeding under the Bankruptcy Act. No other variable in Jaci’s situation had changed other than the fact that the value of her Ottawa condo had significantly increased over the last 8 years. And this is in no small part due to the actions of the Bank of Canada in slashing its key interest rate from 4.5% in July 2007  to 0.75% in April 2015.

So what can we conclude from this?

  • The Bank of Canada’s current policy of continually slashing its interest rate has inflated real estate values to such an extent that home owners are unable to seek debt relief through the Bankruptcy Act. Indeed, the only avenue for debtor/home owners is to either sell their homes and use the sale proceeds to pay off their debts (rendering them homeless) or refinancing their debts through a consolidation loan (for which many may not qualify if they have insufficient equity in their homes).

 

  • Keeping interest rates so low has encouraged consumers to take on even more debt by creating a vicious circle: low interest mortgages allow people to borrow more money, more money in a home purchaser’s pocket allows her to increase what she’s willing to pay for a new home, this in turn creates inflated housing values, which then in turn requires subsequent home buyers to borrow even more money to gain access to a yet more expensive real estate market.

 

As we saw during the American housing crisis of 2007 which led up to the financial crisis of 2008, this will all end very badly.

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