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Risks of Rising Consumer Debt

Posted by commendatori on August 2, 2008

Over the past decade we’ve seen lower interest rates, a robust housing market, and virtually unlimited options when it comes to personal loans. The end result is that Americans are borrowing money at a record pace – consumer debt is on the rise. Still the question remains – What are the real versus perceived risks of rising consumer debt?

In this article we’re going to discuss the role debt plays in fueling the economy. To do that we’re first going to talk about concepts such as the money multiplier and how this economic concept is related to consumer debt. From there we’ll be able to explain both the positive and negative effect that debt can have in America and on consumers.

Consumer Debt in America

In order to understand whether or not rising debt is a problem in America we first need to understand some simple economic rules. For example, when we buy something the money we spend doesn’t simply stop at that store.

In fact many sources typically state that around 70% of our gross domestic product (a common measure of economic growth) is derived from consumer spending. This means that even relatively small changes in consumer spending habits can have fairly large effects on the health of the US economy.

Debt and the Economy

Perhaps the best way to understand debt’s effect on the economy is through the use of an example. Let’s say a consumer decides they want to buy a new car or truck. To buy the truck the consumer is going to increase their debt load – they’re going to borrow money.

When the purchase is finalized, the money doesn’t stop there – it just keeps going. The salesperson collects a commission and the dealership buys another car from the factory. The salesperson now has some extra money as does the factory worker helping produce more trucks.

Money Multiplier

Granted the salesperson and the factory worker need to pay income taxes and they may decide to save some money, but the example has served its purpose. By borrowing money the original consumer has transferred wealth to others. So that original loan has resulted in a multiplier effect – and the economic boom continues.

This money multiplier is often associated with Keynesian economic theory and has been the rationale for using increased government spending or tax cuts to stimulate the US economy. This concept follows the example we gave earlier:

Increased consumer spending is followed by an increase in business revenues. Those revenues result in more jobs which once again result in more spending – and so the cycle continues.

Debt and Interest Rates

The reason we’ve taken the time to talk about the money multiplier is because the availability of personal loansconsumer debt – can have a large effect on the economy. When the government is trying to jump start a sluggish economy one of the many tools they can use is to lower interest rates.

Low interest rates make borrowing easier for consumers and that means more money flows into and through the economy. After all most consumers are merely concerned with how large their monthly payments are and less concerned about how much they’re borrowing. Lower interest rates translate into an increased ability for consumers to handle more debt load

Is Debt Good or Bad?

All of this discussion brings us to this point where we’re trying to figure out if debt is good or bad. On the one hand increased debt helps economic growth while on the other hand many experts question how much further can we expect personal debt to expand.

Debt and Wealth

While personal debt has been on the rise, the vast majority of that debt load increase is associated with home mortgages. And as consumers have borrowed more money to buy bigger homes that mortgage debt has been used to purchase an appreciating asset. As home values increased this translates into increased consumer wealth.

This was a good combination – rising debt followed by rising wealth. Increased wealth means lower chances of default on a loan. After all homeowners with large mortgages were quickly building significant amounts of equity in their homes. If they got into trouble paying back their loans they could always pull some of the equity out of their home or even sell their homes at a profit to pay off their loans.

Collapse of the Housing Market

In fact, this was a good situation until recently when the housing market seemed to slow down. This housing slowdown resulted in a crisis in the sub-prime mortgage market. Borrowers with weaker credit histories, lower household income, and relatively few assets could no longer support their outstanding loans. This resulted in a quick rise in foreclosures and bankruptcies.

Debt Service in the US

One of the more interesting statistics published by the Federal Reserve is the Debt Service Ratio or DSR. The household debt service ratio (DSR) is an estimate of the ratio of monthly debt payments to disposable personal income. Debt payments included in this ratio consist of the estimated required payments on outstanding mortgage and consumer debt.

What the DSR tells us is the how much debt Americans are carrying relative to their disposable income. The higher the debt ratio, the larger the debt burden carried by the consumer. And as of the fourth quarter of 2006 this measure stood at 14.53 – which is the highest ratio in the 26 year history of the indicator.

Current State of Debt

So for the last 25 years or so there wasn’t much to worry about when it came to consumer debt. The amount of debt was rising but much of it was going to buy larger homes. The housing market itself helped support this rising debt because home prices were appreciating and therefore helping to build consumer wealth.

More recently housing prices started reversing themselves and interest rates began to rise. Suddenly buying a larger home no longer guaranteed an abundant supply of home equity. Higher interest rates only added to this problem.

What worries some economists is that consumers can no longer depend on relatively inexpensive home equity loans to satisfy their overzealous purchasing habits. The fear is that consumers will start to depend on more risky and expensive sources of money such as credit card debt – which is unsecured debt. Many feel this type of borrowing will quickly followed by a rapid rise in bankruptcy.

Only time will tell us whether or not these “doom and gloom” predictions made by some economists will come true. Until then we’ll have to keep a close eye on leading indicators such as rising credit card debt and be thankful that we now understand the true risk of rising consumer debt.

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