New data from Transunion, one of Canada's largest credit bureaus, shows that subprime has become the fastest-growing borrower segment, which could be a harbinger of a recession.
According to Better Dwelling, it comes as a surprise to many that Canadians have been balancing high debt burdens and credit quality for more than a decade, but that era may be over. Data from Transunion Canada shows a surge in subprime borrowers in the second quarter of 2023.
Can't hold it! Lenders lend subprime loans
This leads to higher risk for borrowers due to the rising cost of living and rising interest rates together. At the same time, lenders are beginning to accept this fact and are starting to issue new loans to high-risk borrowers. Subprime lending is now growing significantly faster than high-quality lending.
Subprime borrowing in Canada has become the fastest growing credit sector. The number of subprime borrowers jumped 9% over the past year to 2.64 million in the second quarter of 2023. The growth rate of high-risk borrowers is almost twice the growth rate of near-quality borrowers and high-quality borrowers (5%), more than 4 times the growth rate of high-quality borrowers, and higher than that of high-quality borrowers (2%).
Then you may have to ask, what is subprime mortgage. Subprime loans are loans issued to borrowers with poor credit histories and high credit risk. These borrowers may have low credit scores, unstable incomes, high debt loads, or other factors that make them ineligible for traditional loan eligibility criteria.
- High-risk borrowers: Borrowers have a high credit risk and may have past credit problems, delinquent records, or defaults.
- High interest rates: Subprime mortgages typically have higher interest rates due to the high-risk nature of borrowers.
- Unfavorable loan terms: These loans may come with more fees, stricter terms and conditions to protect the lender from the risk of potential default by the borrower.
- Greater risk of default: Subprime mortgages are also at higher risk in terms of default (failure to repay on time) due to higher borrower risk.
Matthew Fabian, director of research and industry insights at Transunion Canada, warned: "While the number of consumers with higher credit balances increased across all risk levels, the highest-risk sub-consumer groups grew by 8.9 per cent year-over-year. ”
Canadians are using loans to make up for the gap
Credit demand remains high and balances are climbing. Credit inquiries grew 17% in the second quarter of 2023 compared to the same period last year. Fabian said that RFQs are a prerequisite for credit applications, and the growth trend is consistent across the risk spectrum.
The increase in credit demand was mainly attributed to the rising cost of living and higher interest costs.
When income can't keep up with the cost of living, the difference can be made up with credit. The longer the problem lasts, the more this gap will accumulate.
For more than 5 years, Canada has been warned that high debt burdens are a household debt risk. In 2020, the problem began to get worse as cheap money flooded into the credit market to spur investment and boost mortgages.
Now, with the end of the post-global financial crisis (GFC) monetary easing era, this risk is not realized. And, now those risks are now amplified by excess demand driven by the Bank of Canada (BoC).
Both of these factors could drive a surge in subprime borrowers. However, the former probably does most of the heavy lifting. Two characteristics of subprime accounts are that income is challenged by the cost of living, and the relatively small size of credit accounts. An increase in the cost of living is more likely to pose a budget challenge than an increase in interest on a relatively small balance.
Are lenders risky?
Surprisingly, Canadian lenders are now interested in taking on more risk.
This trend is easy to spot because the number of subprime mortgage borrowers is now increasing dramatically. However, credit bureaus found that higher risk below prime loan originations climbed 16% in the second quarter of 2023. In contrast, those with quality or better credit scores drove only 6% growth in new loans.
The purpose of raising interest rates is to curb credit, but TransUnion doesn't seem to think it's a good idea. Fabian explained: "In the current macroeconomic context, lenders have remained stable in balancing risk strategies, but this environment continues to put some Canadians under pressure as balances grow and minimum payments are higher than before," Fabian explained. ”
However, he suggested that "... Lenders should maintain a growth strategy that allows for financial inclusion, with a focus on resilient consumers and helping those vulnerable to economic shocks. ”
Canada's six largest banks have increased their default reserves in case of loan defaults
Excessive leverage can lead to recession
While counterintuitive, restricting credit could cause consumer demand to fall faster. If the economy is down, tighter credit restrictions could amplify the negative shock. A deeper, longer recession is not what anyone thinks is a good time.
In other words, a vicious circle.
The researchers also found that overleveraged investors using subprime lenders were responsible for exacerbating the recession.
As a wise man once said, subprime borrowers live in a constant recession: underwages and job and housing instability are problems they face on a daily basis.
In blunt terms, their life is a big, long decline. High interest rates add to an already hard-to-pay debt.
Recessions also tend to hit overleveraged amateur investors harder because they are unprepared for changes in market conditions.