One Nation, Over Charged

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From Standard & Poor's RatingsDirect

What's in the Cards

Credit-card debt has dropped as a share of income. Federal Reserve data show balances up 6.8%, but outstanding debt has fallen to 8.7% of disposable income in July from 8.9% a year earlier, though well above its 4.7% historical average. It's likely that much of the decline in balances was from consumers refinancing their credit-card debt into their mortgage to take advantage of lower rates and tax deductibility. While credit-card debt is expected to rise in 2006 as refinancing opportunities become slim, cheaper sources of borrowing and debit-card spending will continue to dampen credit-card growth.

Low interest rates ignited already heightened American eagerness to borrow. Most consumers don't care how much they owe but only how much they have to pay back each month. Low interest rates (and extended amortization periods) have kept debt service costs at a record—but still affordable—13.9% of disposable income in the second quarter of 2006.

If we add in leases, property taxes, insurance, and rents (to take account of new homeowners no longer having a rent payment), total financial obligations are 18.7% of disposable income, another record. Although the ratio is higher than its 17.1% historical average, it's only slightly above the 17.8% reached in 1987, when debt was lower but interest rates were higher.

Three Categories

What happens as interest rates rise? Headlines suggest that a collapse in the housing market, with a rapid slowdown in consumer spending, is inevitable. But fortunately, most American debt is fixed rate. Only about 12% of new mortgages have adjustable rates, with the rest being either "hybrid" mortgages, where the rate is fixed for 3 to 10 years, or old-fashioned fixed-rate mortgages (62% of 2004's total).

Recent refinancing activity has indicated some movement away from variable rates. The option adjustable-rate mortgage, under which the rate is generally variable but the monthly payment can be chosen, even to allow negative amortization, remains popular, though its dangers are becoming more obvious (see BusinessWeek, 9/11/06, "Nightmare Mortgages").

Even most nonmortgage debt is fixed rate. Consumer debt can be separated into three relatively equal parts: revolving debt (credit cards), auto loans, and "other," which includes broker loans, boat loans, recreational vehicles and motor homes, and other consumer loans not secured by real estate. The last two categories are generally fixed-rate loans, with maturities that range widely. Although credit-card rates are variable, they vary less than short-term market rates.

Despite increasing headwinds, consumer finances are apparently still holding up. The recent Mortgage Bankers Assn. (MBA) survey indicated that the U.S. delinquency rate for all mortgages was 4.39% in the second quarter, down 2 basis points from the quarter before. The percentages of loans delinquent 90 days or seriously delinquent both fell for the quarter. The number of loans delinquent for 30 days rose, retracing the drop reported in the first quarter.

Last Chance to Refinance

Although most households appear able to make their monthly payments, there are some unsettling currents. The MBA reports indicated that delinquency rates have started to creep up in certain sectors, though still low historically. Adjustable-rate mortgages (ARMs) had higher delinquency rates in the second quarter over the first quarter, while fixed-rate mortgage loans were either unchanged or saw a decline in delinquencies. Moreover, CreditForecast.com reported that credit quality deteriorated across the board. Overall, the recent data is mixed, with weakness among ARMs in particular.

Household borrowing is expected to slow as interest rates rise, but nonmortgage debt is expected to increase. Loans not secured by real estate have been weak in recent years, in part because of the refinancing boom, which has led many borrowers to consolidate their debt into their mortgages. Since mortgages generally have lower rates and are tax-deductible, the move has been very rational.

But with mortgage rates climbing, the opportunities for refinancing are coming to an end. We expect refinancing to remain strong for a few months, since borrowers with ARMs are getting scared and refinancing into fixed-rate mortgages. After this final surge, however, activity will drop sharply. The end of the refinancing boom will bring a shift to home-equity loans and credit-card borrowing.

Although interest rates are rising, steady paychecks should keep losses down over the next few quarters. The ability to repay loans depends far more on employment than on interest rates. We expect monthly job gains to average 150,000 in 2006. However, recent job data is mixed, with payrolls disappointing but the lower unemployment rate still indicating jobs are being had. Whether monthly employment reports continue to show disappointing job gains will be key to assessing future trends.

Wyss is chief economist for Standard & Poor's in New York. Bovino is a senior economist for Standard & Poor's.