The Federal Reserve and other U.S. government agencies measure household debt levels using several tools, including the debt service ratio, which is an estimate of the ratio of mortgage and consumer debt payments to disposable personal income. The disposable personal income is what's left after taxes and deductions. The causes and consequences of rising household debt levels are important to understand because they have a bearing on the overall economy.
Facts
According to the Federal Reserve, the debt service ratio was 11.75 percent in the fourth quarter of 2010. It rose steadily from the mid-1990s to about the third quarter of 2007, when it peaked at around 14 percent. Justin Lahart and Mark Whitehouse of The Wall Street Journal reported that total household debt, which includes mortgages and credit cards, fell to a six-year low in early 2011, partly from loan defaults and cutting back on expenses.
Causes
In a 2007 research paper published by the Reserve Bank of Australia, Federal Reserve economist Karen E. Dynan and former Federal Reserve governor Donald L. Kohn suggested that when times are good and there is not much economic uncertainty, households tend to become less patient and less risk-averse. This means higher spending, less saving and more borrowing, which lead to higher household debt. Research done by Berkeley Haas School of Business professor Atif Mian and Chicago Booth School of Business professor Amir Sufi, chronicled in a 2009 National Public Radio website article by Laura Conaway, shows that lenders make mortgages more readily available during boom times, driving up homeownership, home construction activity, home prices and mortgage debt levels. Policy responses, particularly bailouts of financial institutions, create an environment where businesses take risks knowing that taxpayers are likely to be there if things go wrong.
Consequences
Dynan and Kohn suggest that increasing debt levels make households more susceptible to shocks, such as sudden loss of employment, rising interest rates or adverse changes in health conditions. Reductions in income usually mean cutting back on expenditures, including debt payments. Rising interest rates can mean higher debt payments, which can also create shocks on households with high debt levels. Falling housing prices may make it difficult for homeowners to refinance or sell their properties. Rising debt levels may also mean unsustainable low savings levels at retirement.
Debt Reduction Strategies
Rising household debt reduces flexibility when economic conditions worsen because debt payments take up increasing amounts of dwindling disposable income and profits. The improving individual and business balance sheets in early 2011 suggest that both businesses and individuals were taking prudent steps to reduce their debt levels. Lahart and Whitehouse cited several examples of individuals selling off some of their assets and controlling expenses to reduce their household debt. Refinancing in a lower-rate environment improves cash flow and makes the debt more manageable.
