The #1 Risk For Investors And The Economy

Recently there’s been a lot of talk by government officials regarding the level of debt Canadians have amassed. If you’re on my Facebook page or following me on Twitter, you may have seen some of the articles I’ve been posting about it.

Bank of Canada governor Mark Carney and Federal Finance Minister Jim Flaherty have repeatedly warned about Canadian’s debt levels, and there’s even a hint of increased interest rates in the near future to ‘rein in’ that debt.

 

Canadians in general are pretty smug when they talk about the state of the real estate market and their personal finances…

“What happened in the US could never happen here.
We have one of the strongest banking industries in the world.”

While it may be true that our banks are not playing investment games with our deposits (unlike some of the US banks that triggered the 2008 financial crisis), Canadians debt levels have skyrocketed over the last few years. In fact, we have surpassed American debt levels a few years ago.

It’s so alarming, that Bank of Canada Mark Carney has declared that high debt levels are the number one risk to the economyThat should tell you something.

 

While there are many factors that contribute, I think the cause of this increased debt is two-fold:

  • Interest rates are at all time lows
  • Lack of financial education

 

Interest Rates At All-Time Lows

While credit card interest rates aren’t coming down, mortgage interest rates are at all-time lows.  This has allowed Canadians to tap into the equity in their homes to consolidate debt or fund new purchases, essentially treating their homes as an ‘ATM machine’.

In addition, low rates have allowed people who were previously renting to buy a home.  This increased demand for housing naturally causes prices to increase, not only for starter homes, but also for more expensive homes, as Canadians upgrade to previously ‘unaffordable’ housing.

This is one of the reasons why I’ve been saying for awhile that a market correction is coming.  At some point, the Bank of Canada will raise rates to combat inflation, which will raise mortgage interest rates and ultimately make some homes unaffordable for people.

It won’t happen right away, and it won’t happen to the same degree in all markets, but as mortgages come up for renewal, many people will be forced to sell. As a result, more inventory on the market will cause a reduction in overall property values in various towns and cities.

 

 

Lack Of Financial Education

This is the bigger problem Canadians face, as it existed long before low interest rates were around.  There is no required financial literacy training in grade school, high school, or college/university.  If you are lucky, you might take a ‘home economics’ course in high school (like I did) that taught basic budgeting skills, but financial literacy goes FAR beyond that.

That is why I am a big fan of Robert Kiyosaki and his Rich Dad series of books.  He teaches people financial literacy skills that help them learn to invest in paper assets (like the stock market), start businesses, and of course invest in real estate.

He also shows people how to spend their money wisely – to avoid ‘doodads’ or the typical unnecessary expenses that people incur, often on credit cards or home equity lines of credit.  That is where the big problem lies… basic financial literacy must be taught in schools, but it currently isn’t.

 

Take a look at this 2009 Canadian Financial Capability Survey (CFCS) by Statistics Canada.  The task force for the survey defined financial literacy as “having the knowledge, skills and confidence to make responsible financial decisions”.

Here are the questions they asked, along with the answers.  Don’t scroll too far if you want to take the quiz yourself (which I recommend):

Questions

1. If the inflation rate is 5% and the interest rate you get on your savings is 3%, will your savings have at least as much buying power in a year’s time?

a) Yes
b) No

2. A credit report is… ?

a) A list of your financial assets and liabilities
b) A monthly credit card statement
c) A loan and bill payment history
d) A credit line with a financial institution

3. Who insures your stocks in the stock market?

a) The National Deposit Insurance Corporation
b) The Securities and Exchange Commission
c) The Bank of Canada
d) No one

4. True or false…

By using unit pricing at the grocery store, you can easily compare the cost of any brand and any package size.

a) True
b) False

5. If each of the following persons had the same amount of take home pay, who would need the greatest amount of life insurance?

a) A young single woman with two young children
b) A young single woman without children
c) An elderly retired man, with a wife who is also retired
d) A young married man without children

6. If you had a savings account at a bank, which of the following statements would be correct concerning the interest rate that you would earn on this account?

a) Sales tax may be charged on the interest that you earn
b) You cannot earn interest until you pass your 18th birthday
c) Earnings from savings account interest may not be taxed
d) Income tax may be charged on the interest if your income is high enough

7. Inflation can cause difficulty in many ways. Which group would have the greatest problem during periods of high inflation that lasts several years?

a) Young working couples with no children
b) Young working couples with children
c) Older working couples saving for retirement
d) Older people living on fixed retirement income

8. Lindsay has saved $12,000 for her university expenses by working part-time. Her plan is to start university next year and she needs all of the money she saved. Which of the following is the safest place for her university money?

a) Corporate bonds
b) Mutual Funds
c) A bank savings account
d) Locked in a safe at home
e) Stocks

9. Which of the following types of investment would best protect the purchasing power of a family’s savings in the event of a sudden increase in inflation?

a) A twenty-five year corporate bond
b) A house financed with a fixed-rate mortgage
c) A 10-year bond issued by a corporation
d) A certificate of deposit at a bank

10. Under which of the following circumstances would it be financially beneficial to borrow money to buy something now and repay it with future income?

a) When something goes on sale
b) When the interest on the loan is greater than the interest obtained from a savings account
c) When buying something on credit allows someone to get a much better paying job
d) It is always more beneficial to borrow money to buy something now and repay it with future income

11. Which of the following statements is not correct about most ATM (Automated Teller Machine) cards?

a) You can get cash anywhere in the world with no fee
b) You must have a bank account to have an ATM card
c) You can generally get cash 24 hours-a-day
d) You can generally obtain information concerning your bank balance at an ATM machine

12. Which of the following can hurt your credit rating?

a) Making late payments on loans and debts
b) Staying in one job too long
c) Living in the same location too long
d) Using your credit card frequently for purchases

13. What can affect the amount of interest that you would pay on a loan?

a) Your credit rating
b) How much you borrow
c) How long you take to repay the loan
d) All of the above

14. Which of the following will help lower the cost of a house?

a) Paying off the mortgage over a long period of time
b) Agreeing to pay the current rate of interest on the mortgage for as many years as possible
c) Making a larger down payment at the time of purchase
d) Making a smaller down payment at the time of purchase

 

And now for the answers…

Answers

  1. b
  2. c
  3. d
  4. a
  5. a
  6. c and d
  7. d
  1. c
  2. b
  3. c
  4. a
  5. a
  6. d
  7. c

 

 

The conclusions from the survey were interesting, although a bit mixed. What I found incredible was a table that showed the percentage who correctly answered the question as compared to their total debt levels.  Check this out…

Proportion who correctly answered financial quiz question

No debt Household debt All persons1
Under $50,000 $50,000 to $149,999 $150,000 to $249,999 $250,000 and over All debtors
%
Question
1 60 67 72 70 73 69 66
2 29 46 51 53 56 49 42
3 32 34 36 38 42 36 35
4 66 71 73 76 77 73 71
5 71 77 83 80 79 80 77
6 55 60 67 63 65 63 60
7 48 53 57 60 63 57 54
8 57 64 65 67 71 66 63
9 31 39 42 46 47 42 38
10 19 27 32 31 29 29 26
11 55 73 79 79 84 77 69
12 77 90 93 93 92 92 87
13 59 69 74 76 76 72 68
14 76 88 92 91 91 90 85
1. Excludes those who did not answer the Canadian Financial Capability Survey (CFCS) debt module.
Source: Statistics Canada, Canadian Financial Capability Survey (CFCS), 2009.

 

 

What’s so incredible about it?  For most questions, the answers were nowhere NEAR the 90%+ range. That means that a large percentage of people got the questions wrong or didn’t know the answer.

For example, look at question #10…

10. Under which of the following circumstances would it be financially beneficial to borrow money to buy something now and repay it with future income?

a) When something goes on sale
b) When the interest on the loan is greater than the interest obtained from a savings account
c) When buying something on credit allows someone to get a much better paying job
d) It is always more beneficial to borrow money to buy something now and repay it with future income

An average of only 26% of people answered correctly.  This is SCARY!

 

Or take a look at question #3…

3. Who insures your stocks in the stock market?

a) The National Deposit Insurance Corporation
b) The Securities and Exchange Commission
c) The Bank of Canada
d) No one

An average of only 35% of people answered correctly.  Think about that for a second… that means that 65% of people don’t know that the no one insures their investments in the stock market.  Incredible!

 

Why Does All This Matter?

I’ve seen too many new investors ‘load up’ on debt to buy and hold investment properties.  This increases monthly carrying costs, and when investors don’t follow my advice of buying at a discount, often makes properties break even or worse, negative cash flow.

They might be able to handle this for a year, maybe two, but…

  • What happens when a big expense comes along?
  • What if the roof needs replacing?  Or the furnace?
  • What happens when interest rates increase, your mortgage comes up for renewal, and your ‘slightly’ negative cash flow property is now deep in the red every month?

 

You might think I have something against debt… far from it!  With debt comes leverage, and leverage can increase your returns.  I’ve used debt for years to increase my wealth, and you should too. In fact, I even show people how to get 100% financing on investment properties by using other people’s RRSP money.

However, too much debt, at the wrong time, and for the wrong reasons, can be very bad for any investor (new or experienced).  There’s a time and a place to use it, even 100% financing, but without the financial and investing education to know how and when, it’s very very risky.

My advice?  If you’re a new investor and planning to buy a lot of property with little to nothing down, do yourself a huge favour… get educated. Both in finances and real estate investing.

Any less than that, and you’re rolling the dice…

— Paul

 

Further Reading

 

Are you surprised by the results of the financial literacy quiz?
Leave a comment below with your feedback

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Paul Blacquiere

Paul is an entrepreneur, investor, speaker, and educator.
He's experienced in multi-family properties, renovation, flips,
joint ventures, and is Canada's top RRSP mortgage expert.
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  • Another great post, Paul.

    The stats for question #3 especially shocked me. Sixty-five percent of respondents believed that their stocks are “insured” against losses? Unbelievable. Maybe that explains the large number of baby boomers (involuntarily) delaying their retirement.

    Moe

    • Paul Blacquiere says:

      Thanks Moe. Maybe the question was misleading people with fake answers (for example, the SEC is an American securities regular, not Canadian insurer), but the fact remains the majority got it wrong.

      I think question #10 was the most shocking, but also makes sense considering our average debt levels. Basically 74% of people answered wrong, and 2 out of 3 of the wrong answers involved ‘buying stuff’.

      While I pointed out the questions with 2 lowest rates, there are other questions that are equally disturbing.

      For example, 58% of people didn’t correctly answer what a credit report was (question #2).

      And question for #7, 46% of people answered incorrectly, which points to the fact that most do not understand inflation and who would be affected the most by it.

      Everyone likes to think they know the answers to these and other financial (and investing questions), but the fact is, if they have no training in it other than word of mouth and from their parents, they probably aren’t as knowledgeable as they think.

  • Irene says:

    Great post Paul!

    Definitely did not expect these results. Being in constant contact with other RE investors and business owners, it’s easy to forget what the ‘average’ person knows about investing and debt. Let’s start a lobbying group to push financial literacy into high schools 🙂

    What also surprised me is that there’s almost a positive correlation between household debt and financial knowledge. How do you interpret that? Is it that after getting into debt people start learning about the subject in order to get out of debt? or is it that certain demographics (ex: elderly folks, some cultures) that don’t ‘believe’ in debt and credit cards are simply not aware of some aspects of the financial system?

    I hope that this information at least gets people talking about this issue. Thank you!

    • Paul Blacquiere says:

      Thanks Irene.

      It could be that people with higher debt levels can afford higher education – e.g. books, home study courses, college/university programs, premium cable TV channels 😉

      Seriously, people with little to no debt can often (but not always) be the poorer segment of society. They pay with cash because that’s all they have. They learned from their friends and family, who are in the same situation. There are exceptions of course, but I have seen this first-hand.

      I think you are also correct about certain cultures being different. For example, in many countries, there are no mortgages and only cash is used. Perhaps those habits come with them to Canada, and if they are new to the country, they would not have necessarily learned financial education from local friends and family.

      I remember years ago, I attended Darren Weeks first Business Super Conference in Edmonton, and one of the speakers told us something very interesting. He and his colleagues had done research into the education system to see if it had ever taught financial literacy. Apparently, the last time was in the 1920s or so (if I recall correctly), and then it was pulled from the curriculum. I think it’s about time we brought it back!

  • Diego says:

    hi paul great questionaire….maybe you should create/provide more in future blogs to test our knowledge & keep us on our toes!! thanks!!

    • Paul Blacquiere says:

      Good idea! Maybe I’ll come up with some investing quizes 🙂

  • Eva says:

    I so wish I had been taught about handling money, interests rates, mortgages and economics when I was in high school. I was never told how important it was to save for retirement, different ways to invest, or how to use good debt to make money. My parents immigrated from Europe and brought with them their habit of save first, then buy. Debt or loans were not spoken in my home growing up. I thought as long as I had a job and some savings in the bank, it was enough. I wish I had learned how to “make my money work for me”.

    BUT, I am far more educated now. I got only one wrong answer in your quizz (…. after I re-read it, I realized I misinterpreted it). It’s never too late to learn! And I will be educating my children and grandchildren so they don’t make the same mistakes I have.

    Thank you Paul!

    • Paul Blacquiere says:

      Eva, your situation is not uncommon. There are many countries where debt is not commonly used (or it just isn’t available to the average person).

      The problem is that even if the school system begins including financial literacy in its curriculum, who will decide what they teach? Teachers? (who may or may not know anything about finance) Bank reps, mutual fund companies, or financial planners? (who all have a conflict of interest)

      That might be okay for basic levels of financial literacy, but for investment knowledge (such as real estate, stocks, bonds, etc.), I believe most people do much better learning on their own.

      In any case, I love your attitude — it’s never too late to learn! 🙂

  • Sean says:

    I’m also a fan of the Rich Dad books by Kiyosaki. I would say ‘glad to hear we’re not alone’ in the US on this topic, but that would only support the ‘misery loves company’ vibe which I don’t dig. Great post and have to wonder, when in the world are we going to get serious about this type of education in schools. Globally we seem to be reaping what we’ve sown in this lack of education. :/ It’s not just info ‘rich guys’ need, it’s information that everyone needs to have so they understand when and where to enter markets, investments, etc…and when to hold or fold.

    • Paul Blacquiere says:

      Thanks Sean. I think it’s more than just information people need. The problem is that laziness is built into our DNA (always looking for the shortcut) and most people would rather hand over their money (and responsibility for that money) to someone else they feel is smarter than them.

      I recently saw some survey statistics that said over 60% of Canadians still invest in mutual funds, despite the fact that lower cost, more efficient alternatives exist (e.g. ETFs). I’m sure the US stats are similar, and what it shows me is that most people want a clean, easy, hands-off investment, where they don’t have to think too much. They are *too busy* with their lives to worry about such things.

      If they’d only take a step back and see how much money they are losing (in all areas of their finances) through lack of knowledge, they could easily save so much that they wouldn’t have to work so hard and be so busy.

      That’s why I believe this information has to be taught early, starting in grade school, thru high school, college and university. Unfortunately I don’t think the educational system is planning on those types of changes anytime soon…


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