When the Bills Come Due, Then What?
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By KELLY K. SPORS
SUNDAY JOURNAL
The Wall Street Journal Sunday
July 17, 2005
Thanks to rock-bottom interest rates and easy ways to borrow, consumers have been on an all-out spending spree for several years. Now, though, there are signs that the bills may be piling up too high.
The portion of Americans' disposable income devoted to paying off debt hit a record high recently, even though interest rates have stayed at record lows. That could put a financial squeeze on many households if and when long-term interest rates finally start to go up.
U.S. consumers are more vulnerable than ever to rate increases because they've taken on more adjustable-rate debt in recent years -- meaning monthly payments fluctuate when interest rates change.
Nearly half of all consumer debt and 26% of all mortgage debt is now adjustable, estimates Joe Abate, senior economist at Lehman Brothers. That's a stark change from the early 1980s when nearly all debt had fixed rates. Other estimates peg adjustable-rate debt at closer to 20% of all consumer debt.
Adjustable-Rate Crunch
"When all these [adjustable-rate] mortgages reset soon, some of these people are going to see their monthly payments rise by a few hundred dollars a month," Mr. Abate says. "That's a real significant bump for all those people complaining now that gas prices have risen over $2 a gallon."
And recent data suggest the debt burden on households is growing heavier, despite low interest rates. The "debt service ratio," the Federal Reserve's estimate of the ratio of debt payments to after-tax income, hit 13.4% in the first quarter of this year, an all-time high since the Fed began tracking it in 1980. The financial obligations ratio, which adds automobile lease and rent payments, homeowners insurance and property-tax payments to the debt service ratio, was 18.45% last quarter, near the record high of 18.84% in late 2002.
Overall, U.S. consumers now owe roughly $11 trillion, nearly double what they owed a decade ago. The vast majority of that debt growth came from people taking out big mortgages and tapping their escalating home equity. Total household debt grew 11.2% in 2004, the largest year-to-year increase since 1986.
"We're still in the midst of this consumer debt binge," says Kathy Bostjancic, U.S. senior economist at Merrill Lynch & Co. As long as the housing boom continues, "it's going to give consumers a false sense of security."
Many economists including Ms. Bostjancic predict that if mortgage rates see a noticeable rise from the 6% of recent months, many housing markets will slow and prices will flatline, or even drop in some especially hot markets. Oddly, long-term rates have stayed low despite the Fed's steady short-term rate increases that started last summer -- a phenomenon that Fed Chairman Alan Greenspan recently dubbed a "conundrum."
Here's the impact rising rates can have on household finances: A family with a 30-year adjustable-rate mortgage with a 5% interest rate would see its monthly payment jump from $1,074 to $1,468 -- a 37% leap -- if mortgage rates rose to 8%. Couple this with rises in other debt payments such as credit cards, home-equity loans and such, and households may struggle to pay all the bills each month. The rise in payments due could be exacerbated if job growth and incomes don't keep pace.
For consumers, this means it's high time to make a serious dent in their debts, especially those with adjustable-rate debts such as many mortgages, home-equity loans and credit cards. While it may not be realistic to pay off some debts entirely (easier said than done), borrowers can at least make more than the minimum payments each month -- and cut back or stop buying on credit.
After all, most analysts still think that long-term rates have nowhere to go but up, and that there will be a modest increase by year end. Once rates rise, all the consumers who have overloaded themselves with adjustable-rate debt on mortgages, home-equity loans and credit cards will probably see their minimum monthly payments climb. And if housing prices stop rising, they'll be less able to tap their home equity to help cover the swelling bills. In severe cases, if consumers can no longer afford their monthly payments, this could mean more defaults and foreclosures in some cases.
Already, affordability concerns are popping up. A recent analysis of jumbo mortgages, those with loans above $359,650, by Bear Stearns showed that the average initial mortgage payment on mortgages rose to $2,338 in the first quarter of this year, up from $2,060 late last year. It suggests home buyers might be struggling to keep the price of their home low.
Consumers who have taken advantage of innovative loan products like interest-only loans also will feel the pinch of rising rates, since those loans require only interest payments early on, no principal, but require heftier payments later on. And that number has risen significantly during the past couple years: About 27% of all new mortgages so far this year (excluding refinancings) were interest-only, according to LoanPerformance, a unit of First American Corp. that tracks 46 million mortgages monthly and provides information to lenders and others in the industry. Only 1.6% of all new mortgages were interest-only in 2001.
Much of the debt spree reflects unusual market trends in recent years, particularly the housing boom. Even as the U.S. economy sputtered and jobs fizzled in 2001 and 2002, consumers continued to borrow and spend as they did during the raging 1990s bull market.
But as home prices surged and interest rates hit record lows, consumers took out bigger mortgages and started tapping their escalating home equity like a credit card. U.S. regulators kept interest rates low to keep the economy chugging.
'We'll Probably Regret It'
"It was a good strategy in that we needed something to boost the economy in the economic downturn," says Dean Baker, founder of the Washington think tank Center for Economic and Policy Research. "But it sets us up for an even worse crash when housing" cools. "In the long term, we'll probably regret it."
What's more, consumers' attitude about debt is changing, says Robert D. Manning, a finance professor at Rochester Institute of Technology. While older generations are more debt-averse and cut spending during economic downturns, younger generations rely on debt for spending money. "What we're seeing here is really a deferral of the financial responsibility and consequences," Mr. Manning says. "We may be heading into a very gut-wrenching period." |
