Household Debt Near Recession Levels, But This Time’s Different

The notion of the American Dream means something completely different today than it did to prior generations. Previously it represented the hope to own a home, work a stable job and send a kid to college, but to achieve that today requires copious amounts of loans and debt that follow borrowers for life. Major economic and structural changes brought on from the financial crisis, namely low interest rates, increased the likelihood of consumers spending on credit or borrowing to make big purchases. But the biggest factors contributing to the ballooning debt balance emanate from stagnant wage growth and rising cost of living.

Consequently, total household debt climbed to $12.58 trillion at the end of 2016, reflecting a $266 billion increase from the third quarter and $466 billion compared to a year earlier. This share of indebtedness has flirted with levels not seen since the financial crisis, when total liabilities peaked at $12.68 trillion. 

On the surface, many of these figures look alarming, but there remains several stark differences between today and 2008; notably a smaller share of debt related to housing and historically low default rates. Delinquencies dropped from 8.5 percent in the third quarter of 2015 to 4.8 percent in 2016, according to the most recent quarterly report on household debt and credit issued by the Federal Reserve. Other measures of payment distress improved as well, including bankruptcy filings and defaults on mortgage debt, both of which hit near pre-crisis levels. 

Hence, banks have become more reliable at extending credit to the appropriate parties. At the peak of the crisis, the median credit score on new mortgages barely breached 700 with the lowest 10^thpercentile trending below the threshold of bad credit. And now the median measure ranks above 750, signaling a larger swath of homeowners in good/excellent standing. In other words, another housing crisis is less likely if the banks stay committed to weeding out high risk applicants.

Moreover, the composition of household debt has tilted towards non-housing debt, meaning a greater share of student, auto and credit card loans relative to mortgages and home equity lines of credit (HELOC). Mortgage balances and HELOC still represent the largest component of household liabilities, but the share of housing debt dropped to 71 percent from its peak of 79 percent during the crisis. Thenceforth, American’s shed nearly $340 billion in mortgage debt per year with a majority of the extra cash directed to alternative loans. In the fourth quarter, student loan balances rose by $31 billion to $1.3 trillion, whereas auto loans climbed by $22 billion as new loan originations for the year reached record highs. The two segments along with credit card loans now account for 25 percent of total indebtedness.

The boost to balances is the result of high levels of educational attainment and increasing job opportunities. Steady improvements in the labor market provide consumers with deeper pockets to make big purchases like new cars, but it also minimizes the probability of defaulting.

While the makeup of today’s debt looks very different from previous years, excessive borrowing threatens the prospect of economic growth.  At its current level the average U.S household carrying debt owes a resounding $134,643, most of which originate from mortgages and student loans. One of the primary causes for the enlarged balance is higher cost of living relative to income growth. Median household income increased by 28 percent since 2003 whereas the cost of living climbed 30.2 percent. That figure skews higher for residents of major metropolitan cities with greater cost of living. At the same time, real wages (adjusted for inflation) for most workers have barely budged in decades, while wages for the upper echelon grew 138 percent since 1979. The sharp rise in income inequality perpetuated the run up in household debt and created the productivity-pay gap dilemma that makes the prospect of economic growth improbable. 

Conventional wisdom suggests that Americans will owe more by the end of 2017 than at the peak of the Great Recession, but that doesn’t mean another recession is on the horizon. Instead, it introduces a new set of questions about how these trends will play out as the ongoing recovery and Trump administration unfolds.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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