From Standard & Poor's RatingsDirectAmerican 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.

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.