One Nation, Over Charged

Americans' borrowing levels are at historic highs, but there's no cause for alarm quite yet. How much is too much?

by David Wyss and Beth Ann Bovino From Standard & Poor's RatingsDirect

American consumers continue to post historic highs in household-debt holdings, both in absolute terms and relative to income. Despite the record indebtedness, most Americans are keeping up with their monthly payments and are still borrowing. However, the household saving rate has been negative for five consecutive quarters, after falling below zero in the second quarter of 2005 for the first time in the history of the data. Rising interest rates, ongoing high gasoline prices, and the recent slowdown in the job market also hint at weakness around the bend.

Still, the strain on the consumer has been manageable. Long-term interest rates have remained low, despite 17 consecutive rate hikes by the Fed. Low interest rates have kept debt-service costs within a reasonable share of household income, although the ratio of debt service to income is hitting new highs. Greater levels of wealth may also make Americans more inclined to accept more debt, although it's never clear how much of the debt is held by the people who have the wealth. In addition, the U.S. household's new riches are thanks to ever higher home prices, which have started to decline since last summer's highs.

How much will Americans be stressed as interest rates rise? We believe the damage will be modest and that most Americans will be able to meet their debt service payments. However, a minority of households with high debt and variable interest rates will be in more difficulty, especially if the economy falters as rates climb.

Home Improvements

American consumers spearheaded the recovery after the economy collapsed in 2001. They continued to spend heavily over the past four years, despite often having no money in the bank. When oil prices surged to record highs, consumers didn't cut back on energy use or slow their spending on other items. Instead, they saved less. And borrowing surged, with average household debt reaching 134% of after-tax income in the second quarter of 2006, yet another record.

Some factors in the debt picture soften an otherwise scary picture. A record 76% of household borrowing is mortgage debt, and the rise in that category reflects in large part the rise in the homeownership rate to 68.9% at the end of last year, though a bit under 2004's 69.0% record. Ten years ago, mortgage debt was 70% of total debt and the home ownership rate was only 64.7%. This debt is "good" in that it's used to acquire a (presumably) appreciating asset.

Low mortgage rates have made housing very affordable, since a home's effective price for most Americans is the monthly payment. Along with the tax advantages of mortgage debt, low rates have sharply increased homeownership to record highs. And although the mortgage shows up as debt, the home's value shows up as wealth.

Mortgage Matters

A large number of homeowners have tapped into their home equity, hoping that rising prices would let them outpace their debt. Freddie Mac estimates homeowners took out almost $525 billion in 2005. Based on Federal Reserve survey data, we estimate that nearly half of that money is likely to go for consumption.

However, consumers still have ample home equity to borrow against. Mortgage debt has been stable. Though it has edged up to nearly 46% of the value of the average home, it's still near the 10-year average of 43%. The 96% ratio of mortgage debt to disposable income, while more than double the historical average of 47%, reflects the rise in home ownership and prices, not an increase in leverage. Households still have room to raise cash from their homes, but it will cost more than it did in the recent past, and that should discourage borrowing. The weaker housing market and rising mortgage rates will thus deter consumer borrowing and spending, but probably not as much as some people believe.

Increases in the value of real estate boosted wealth, but Americans' financial assets are also at record highs. As a result, the net worth of the average American household is 560% of annual income in the second quarter of 2006, well above its historical average (since 1959) of 482%, although below the 615% peak reached in the 1999 fourth quarter. The sharp rise in home values explains much of the wealth, and it could reverse. But rising stock prices and increased holdings of other financial assets also help.