Believe It: Consumers Are Shedding Debt

My colleague Sean Williams and I agree on one thing: It would be devastating if American consumers fell back into a culture of living beyond their means. The only thing worse than a financial crisis is not learning anything from one. That sets us up to repeat the same mistakes.

But Sean and I may disagree on whether this is actually happening. On Friday, Sean pointed out that consumer credit is again on the rise, personal savings rates are low, and incomes are not keeping up with inflation. "Do the figures I have here point to the beginning stages of one final recessionary dip?" he asked.

I don't think so, and digging deeper into the numbers shows why.

Consumer credit, as Sean points out, is indeed rising again, increasing by some $40 billion in the last two months alone. This could be troubling. I've wondered myself why households haven't gone into full-blown debt paranoia after the scars of 2008 and 2009, as they did after the Great Depression. Changes in bankruptcy laws may explain part of it, but for whatever reason, it's true -- we are back to gobbling up consumer debt.

But this doesn't tell us much about the strength of households' finances. Consumer credit is just one type of debt, and it's a small one, comprising less than one-fifth of all household liabilities. When other forms of debt like mortgages are included, you get a more complete figure of household obligations called household credit market debt outstanding. This figure, in my view, is the true measure of consumer debt outstanding.

And to get a feel for the burden that debt is imposing on households, it should be viewed as a percentage of household income. It's easy to see why. If Bill Gates has $10 million of debt, it's irrelevant. If I have $10 million of debt, I'm bankrupt. What matters when analyzing debt levels are not the raw numbers, but those numbers in context -- in this case, debt as a percentage of income.

So what happens when you take total household liabilities and divided it by disposable income? You get this:

Source: Federal Reserve.

While still a long way from victory (more on that in a minute), consumers are clearly deleveraging, relieving themselves of trillions of dollars in excessive debt accumulated over the last three decades. Far from falling off the debt wagon, consumers are working their way toward more healthy balance sheets. And they're doing a pretty good job of it.

Another way to view this is household debt as a percentage of household assets. Here, too, there's progress:

Source: Federal Reserve.

We're still far from anything worthy of being called healthy, but households are clearly moving in the right direction. Debt as a percentage of assets is heading down.

Some more interesting details come from a recent report on deleveraging by the McKinsey Global Institute. It wrote:

Another way to gauge progress in household deleveraging is to look at the household debt service ratio. This ratio in the United States has declined from 14 percent of disposable income at the peak in 2007 to 11.5 percent -- well below where it stood in 2000. Some of the progress on this metric reflects very low prevailing interest rates, but it is nevertheless a sign that US households are moving in the right direction.

In a separate report two years ago, McKinsey also noted (link opens PDF):

In the United States, contrary to conventional wisdom, the greatest increase in leverage occurred among middle-income households, not the poorest. Most borrowers who did not qualify for the prime mortgage category, in fact, were middle- and higher-income households with poor credit histories, or no down payments, or poor documentation of income -- not low-income households buying a house for the first time.

That should put a lot in perspective. A 2007 Federal Reserve report showed (link opens PDF) household leverage was nearly twice as high among those with incomes in the 80th percentile than those with incomes at the 20th percentile. That's important, because a cruel trend of the last three decades has been that those with lower incomes have seen real (inflation-adjusted) paychecks shrink, while those at the top of the heap have seen their incomes grow. Those with the most debt, in other words, likely have an easier time deleveraging since they are the ones with rising incomes -- important when wondering how consumers can handle debt when aggregate earnings are rising less than inflation.

Make no mistake: There's still a long way to go. McKinsey thinks households could be done deleveraging by the middle of next year. That could be optimistic. Some simple calculations show the economy as a whole could be deleveraging for another decade if we continue at the current pace.

But to answer Sean's question about whether household debt figures point to another recessionary dip, I think the answer is not only no, it's the opposite. The numbers show that consumers truly are putting the bubble behind them, becoming stronger with each passing month as they deleverage and create a more sustainable, rational state of finances. That lowers the odds of another recession.

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. Follow him on Twitter @TMFHousel. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (7) | Recommend This Article (24)

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  • Report this Comment On February 15, 2012, at 4:22 PM, deckdawg wrote:

    Current tax policy & record low mortgage interest rates will keep many households from getting too carried away with deleveraging. It makes pretty good sense to use any extra income to max out contributions to tax advantaged accounts, rather than paying down a 3.75% tax deductible loan. Of course, the debt to assets ratio would continue to improve for these households.

  • Report this Comment On February 15, 2012, at 5:15 PM, KingOfPizza wrote:

    It's true that low interest rates can put deleveraging on the back burner for some. In my case, my net worth grows much more by investing my cash somewhere like Lending Club versus paying extra on my student loans (which currently have an average interest rate <3%, thanks to the Stafford loans and their adjustable rates).

    The flip side is that banks don't care about my growing net worth, only my income-to-debt ratio. As such, I can't get a mortgage until my student loan balances decrease significantly. I would have to give up my current returns of ~12% in favor of the ~3% savings from paying extra on my student loans, and that's just not going to happen.

    Part of the reason the housing market continues to struggle is that recent graduates - even ones with decent incomes and good credit - don't qualify for a mortgage because of their student loan debt. I'd love to buy into this market, but first the banks would require me to do something that is not in my best interest.

  • Report this Comment On February 15, 2012, at 6:27 PM, sfojoe wrote:

    One aspect of the Great Deleveraging of America that fails to get reported is the impact of all of these morgage defaults. Hundreds of billions of dollars of debt has disappeared from the balance sheets of consumers through the miracle of bankruptcy. How much of the deleveraging of the consumer we have seen over the last couple of years is as a result of this factor?

  • Report this Comment On February 15, 2012, at 8:57 PM, BruceHBi wrote:

    If consumer debt isn't being reduced, that leaves primarily secured debt, especially household mortgages. If that is the case, isn't this just a function of fewer people buying homes, or walking away from the ones they can no longer afford?

    It seems to me we may need to wait a bit before drawing too many conclusions.

  • Report this Comment On February 15, 2012, at 11:12 PM, gcp3rd wrote:

    Bruce I think it's both. As a real estate broker in Chicago I just listed 6 short sale listings *in a row*! While not every one gets agreed to most do eventually and those owners get out from under secured/mortgage debt. On the other side of the coin don't underestimate the desire to get the monkey of consumer debt off one's back. I will pay off my last credit card with a long term running balance in a few months. This is debt that ultimately started about 12 years ago after I got a "good" job and involved probably 8 or so credit cards over the course of time though I've only had 3-4 at a time. A friend of mine refuses to fund his IRA until his credit card debt is gone...going forward we'll see if people can actually kick the habit long term. I know I will. :-)

  • Report this Comment On February 16, 2012, at 2:17 AM, yonkmember wrote:

    Hey Morgan,

    Nice article. The negative slope of the household debt versus assets graph is a positive sign, but how much of that decline is simply related to the stock market advancing considerably over the past few years?

    Keep up the good work!

  • Report this Comment On February 16, 2012, at 9:35 AM, Tygered wrote:

    Another thoughtful article Morgan. My thanks.

    We have sort of been forced to deleverage (we meaning Americans) because if you lose your job then you have to cut expenses and if you lose your house, you of course lose the debt associated with that house. I too would like to know what percentage of debt is deleveraged because of bankruptcy.

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