By: Liz Strait, PhD
Introduction
Recently, total household debt, credit card delinquencies, and variable interest rates have all increased. As the U.S. experiences a credit crunch, more households are facing financial strain and distress. The financial health of the population is deteriorating, and it isn’t limited to particular segments. As a Financial Professional (FP), it is important to understand how interest rates, inflation, and a credit crunch can adversely impact your clients. While it may be tempting to assume that the negative effects of these trends are limited to subprime borrowers, delinquent accounts, or low-income earners, this would be an unwise assumption. All of an FP’s clients could be impacted—and to varying degrees—by changes in the credit landscape. For this reason, it is essential for FPs to understand how behavioral biases can magnify the impact of these variables and lead clients to deviate from their financial plans.
Background
Total Household Debt
Total household debt is the outstanding balance of all loans a household may carry—mortgage, revolving home equity, auto, credit card, student, and other. Tracking household debt is one indicator of financial well-being for Americans and the health of the economy as a whole. Increased household debt can be a signal of consumer confidence—increased borrowing suggests individuals believe the economy will remain strong. Total household debt is directly impacted by the interest rate—higher interest rates are meant to dissuade borrowing and reduce total debt, while lower ones have the opposite effect. Examining the composition of household debt can also provide insights into lending products that are becoming increasingly expensive or relied upon by households. As Figure 1 shows, the composition of household debt hasn’t changed much in the last five years, suggesting that if total debt is increasing, it is because all products are becoming more expensive. This makes sense given the interest rate hikes that have been occurring since March 2022.
Figure 1
Source: Federal Reserve Board of New York & Equifax Credit Panel Data (August 2023).
Note: Dollar amounts have not been inflation adjusted since the goal was to show composition (proportion), and adjustment will not affect this.
In terms of understanding the true financial well-being of a U.S. household, however, it is also important to understand how income relates to total household debt. If debt is rising and incomes are not, more Americans will fall into financial distress—and this is not just limited to lower-income households. The most relied upon indicator of general financial health is the debt-to-income ratio (DTI). This is defined as the total monthly (or annual) amount of household debt divided by net monthly (or annual) income.1 The maximum DTI allowed to qualify for a mortgage usually hovers around 43%.2 This means that as DTI increases, more consumers will be priced out of credit markets. DTI can increase when there is inflation and credit becomes increasingly expensive, while incomes remain stable or grow below the rate of inflation, which has been the case since April 2022.3 Overall, American households are paying more for their debt each month and the number of households being priced out of credit markets is increasing as a result.
Figure 2
Source: Federal Reserve Board of New York & Equifax Credit Panel Data (August 2023).
Notes: (1) All dollar amounts have been adjusted for inflation (via the CPI Index) to July 2023 dollars using the Bureau of Labor Statistics (BLS) inflation calculator (accessible here: https://data.bls.gov/cgi-bin/cpicalc.pl). (2)Total household debt is the sum of outstanding debt balances for mortgages, revolving home equity (HELOC), auto loans, credit cards, student loans, and other.
When we look at the poverty rate in the U.S. (Figure 3), this indicator of financial well-being is also grim. The poverty rate, after governmental assistance (both cash and other forms), is currently at 14%—having risen sharply when COVID-19-related assistance ended. While still lower than other years, it is at the highest is has been since 2016. As inflation continues to erode real incomes, it is likely the poverty rate will continue to grow. It is also not only the lowest-income earners who will be adversely affected. Interestingly, income inequality (the difference in pre-tax income between the highest-earning and lowest-earning 10% of U.S. households) has actually decreased. This is because the decline in median household incomes has been borne primarily by households at the top and middle of the income distribution.4
Figure 3
Source: Center on Poverty and Social Policy at Columbia University.
Notes: (1) The poverty rate shown is the Supplemental Poverty Measure (SPM). The U.S. Census measures both the Official Poverty Measure (OPM), which is based on cash resources, and the SPM, which includes both cash and non-cash benefits and subtracts necessary expenses (e.g., taxes, medical expenses). The SPM is generally considered a more comprehensive measure because it accounts for modern forms of income, benefits, expenses, and regional cost-of-living differences.5 (2) The dotted line is the historical rate including government assistance. For example, during the COVID-19 pandemic, this rate was inclusive of any COVID-19 financial relief. The difference between the solid line and this line can be interpreted as the reduction in the poverty rate attributable to resources from government assistance programs.
Variable Interest Rates
As total household debt increases, we are also seeing increased delinquencies across credit products. As shown below, the percent of accounts moving into delinquency has increased for credit cards, auto loans, and mortgages since the end of 2021. These delinquencies suggest that households are increasingly unable to meet their debt obligations. In previous posts I have discussed the auto loan, mortgage, and student loan side of borrowing and household resources. In this post I’m going to focus on credit card debt—a loan type that has variable interest rates. While mortgages and auto loans can have variable rates, they are a much smaller portion of the borrowing landscape within those categories. Credit cards are the inverse of that—most credit cards have variable APRs, while fixed-rate cards are rather rare. While HELOCs also mostly have variable rates, they are much less widely available than credit cards (though HELOC originations have been on the rise).
Figure 4
Source: Federal Reserve Board of New York & Equifax Credit Panel Data (August 2023).
Notes: (1) New delinquencies are any accounts 30 or more days delinquent. (2) Dollar amounts have not been inflation-adjusted since the goal was to show percentage of total accounts and adjustment will not affect this.
The variable nature of credit card rates makes any individual holding them financially vulnerable if rates increase and they carry an outstanding balance. Even if a consumer stops spending on a given card, if that card has a balance and rates increase, their debt obligation necessarily increases. The increasing cost of credit card debt will affect almost half of credit card holders in the US.6 As of 2021, 84% of Americans had at least one credit card.7 That means over 131 million Americans have an outstanding credit card balance and are thus facing increasingly expensive credit card debt as inflation and interest rates continue to climb.
While new credit card delinquencies are nowhere near where they were during the fallout from the 2008 financial crisis, they have been growing at an increasing rate (demonstrated by the steep slope for both early and serious new delinquencies from mid-2022 to mid-2023 shown in Figure 5). Increasing delinquencies don’t just affect the individuals who are delinquent, but financial institutions and the broader economy as well. As more accounts become past due, the stability of financial institutions can be challenged. This is because delinquencies can lead to more write-offs, which amount to direct financial losses; require higher reserves which could be used for other activities; reduce profitability; and result in stricter credit standards, making it more difficult for all borrowers to access credit.
Figure 5
Source: Federal Reserve Board of New York & Equifax Credit Panel Data (August 2023).
Notes:(1) New early delinquencies are accounts that have just moved into being 30 days delinquent. New serious delinquencies are accounts that have moved from early delinquency into being delinquent for 60 or 90 days (though definitions of serious delinquency can be lender-dependent). (2) Dollar amounts have not been inflation-adjusted since the goal was to show percentage of total accounts and adjustment will not affect this.
As interest rates on existing accounts increase, there is no reason to expect this sharp incline in credit card delinquencies to plateau or decrease. Currently, the rate sits at 20.68%—this is over four percentage points higher than it has been in almost thirty years. Even more relevant is the fact that the rate has jumped over 6 percentage points since Q4 2021 when it was 14.51%. So, in a matter of 18 months, monthly payments have increased by approximately 143% (at a minimum) for the average credit card holder.8 This is a substantial amount. Of course, this was what was supposed to happen with increased interest rates being used to combat inflation—the cost of borrowing increases, serving to decrease spending and curb inflation as a result.
Figure 6
Source: Federal Reserve Economic Data (FRED), St. Louis Federal Reserve Board.
Note: Interest rates shown are those for existing credit card accounts, not new accounts. These interest rates are charged based on existing balances.
Pricing Out Subprime Borrowers
A major theme from the squeeze on household finances, is that subprime borrowers are being forced out of the credit market. This is happening with both auto and home loans. And it is happening with credit card lending as well. This tightening of lending standards will obviously reduce subprime borrowers’ access to traditional credit products: mortgages, auto loans, credit cards, and personal loans. Importantly, the effect of this credit crunch is not contained to subprime borrowers—everyone stands to lose when these borrowers are restricted from accessing credit. Specifically, it can reduce lenders’ profitability—subprime borrowers are high-risk, but that means they are also high reward. If this revenue stream was removed, lenders would have to find alternative avenues for maintaining profitability. This could result in layoffs, reduced credit availability overall, the introduction of additional fees, and, while less likely, higher borrowing rates across credit score categories. Reduced access can also impact the economy by stifling economic growth—an inability to get credit can reduce entrepreneurial activity, homeownership, and other drivers of the economy. At a societal level, pricing subprime borrowers out of the credit market can increase income inequality and reduce economic mobility.
End Notes
[1] For example, if monthly household debt is $5,000 and monthly net income is $10,000, that household’s DTI is 50%.
[2] Fay, Bill.“Demographics of Debt.” Debt.org, 21 Jul 2023, https://www.debt.org/faqs/americans-in-debt/demographics/.
[3] For example, the inflation rate for 2022 was 8.0% according to the Bureau of Labor Statistics (BLS). Median household income (after taxes) has been declining since 2019. This means that inflation is outpacing income growth—as a result, the purchasing power of a household has been decreasing rapidly. See also: Historical Inflation Rates: 1914-2023 accessible here: https://www.usinflationcalculator.com/inflation/historical-inflation-rates/.
[4] Casselman, Ben, and Lydia DePillis. “Poverty Rate Soared in 2022 as Aid Ended and Prices Rose.” The New York Times, 12 Sep 2023, https://www.nytimes.com/2023/09/12/business/economy/income-poverty-health-insurance.html.
[5] See: https://www.census.gov/newsroom/blogs/random-samplings/2022/09/difference-supplemental-and-official-poverty-measures.html#. See also: https://www.povertycenter.columbia.edu/historical-spm-data.
[6] According to Bankrate, 47% of American credit card holders carry a balance month-to-month. See: Thangavelu, Poonkulali. “More Cardholders Carrying Credit Card Balances In High Rate Environment.” Bankrate, 9 Aug 2023, https://www.bankrate.com/finance/credit-cards/credit-card-debt-survey/.
[7] Pokora, Becky.“Credit Card Statistics and Trends 2023.” Forbes, 9 Mar 2023, https://www.forbes.com/advisor/credit-cards/credit-card-statistics/.
[8] The average credit card balance is $5,474 according to Forbes. If we calculate the simple monthly interest of a $5,474 balance with a 14.51% rate, the cost is $66.19. If we calculate the simple monthly interest of a $5,464 balance with a 20.68% rate, the cost is $94.32. This is likely the minimum increase as many credit cards calculate interest on a weekly or monthly basis, leading to increased cost due to compounding.
[10] https://www.nytimes.com/2023/08/18/your-money/credit-card-debt.html.
[12] To calculate the real interest rate you use the following formula: real interest rate = (1 + Nominal Interest Rate)/(1 + Inflation Rate) – 1. For the example described in the text, this would be: real interest rate = (1 +.0475)/(1 + .037) – 1 = 1.0475/1.037 – 1 = 1.0101 – 1 = .0101 or a real interest rate of 1.01%.