U.S. Household Debt and Savings Rates: Much Ado About Nothing

According to many experts, the economy is at risk of collapsing under the enormous weight of consumer debt. This theory holds that homeowners owe so much money on their mortgages that it’s just a matter of time until they have to cut back on their spending, default on their payments, or both.

It’s true that mortgage debt has increased in recent years. Since 2000, it has gone up by more than 10 percent each year, far outpacing household income, which has only climbed by 4.5 percent a year. And the disappointing performance of the stock market hasn’t helped.

Even when we factor in the impact of soaring real estate values, which have increased by nearly 8 percent a year, household net worth has risen by only 2 percent a year.

But the situation is not as gloomy as it seems. Despite rising mortgage debt, Americans have $55 trillion in total household assets, such as real estate, bank accounts, stocks, bonds, and mutual funds. This is five and half times the total household liabilities of $10 trillion.

Another positive sign is that, even after the frenzy of refinancing and the popularity of home equity loans, Americans hold 55 percent of the equity in their homes. This is almost the same level of home equity ownership that people held at the peak in 2000, when the level was 57 percent.

While borrowing has increased, it has not spiraled wildly out of control, as some news reports would have you believe. In 1997, household liabilities were 96.5 percent of after-tax household income. Today, they have only gone up to 115 percent. However, in any normal business sense that’s hardly poor debt coverage, as Milton Ezrati, senior economic strategist for Lord, Abbett & Co. LLC, recently pointed out in an analysis.

If we look even closer at household liabilities, the situation looks even better. While mortgage debt has gone up, other borrowing hasn’t risen significantly. For example, consumer credit is up only 4.5 percent a year, which is the same rate at which household income is growing.

What this means is that instead of maxing out their credit cards and paying 20 percent interest on their unpaid balances, people are borrowing against their home equity or paying down their mortgages at 5 percent. Because of the tax benefits of mortgage debt, the burden of debt service on after-tax income is actually dropping ? from 15.5 percent in 2000 to 13.5 percent today.

As we can see, it’s highly unlikely that overburdened consumers are going to fall into mass default and bankruptcy, bringing down the economy. However, it is reasonable to be concerned about the low savings rate in the United States. If people really aren’t saving enough to meet their future needs, at some point they’ll have to stop spending ?and this drop in consumption could slow down the economy.

To understand this risk, let’s explore the household savings rate in more detail.

There are conflicting numbers about the savings rate, but all of them appear troubling, on the surface at least. For example, the Bureau of Economic Analysis reports that Americans save only 1.5 percent of income. Meanwhile, the Federal Reserve estimates the figure at 3 to 4 percent of income.

Either way, the numbers are plunging. Over the past quarter-century, the savings rate has fallen by 7 to 9 percent of income overall. Moreover, all of this decline has been traced by the Fed to the top 20 percent of the population according to income. In other words, those who earn the most are saving less than ever, while the other 80 percent of the population is saving at roughly the same rate as they always have.

What would cause this change in savings among the wealthy? There are three possible explanations:

People didn’t need to save because their other investments were performing so well. Consider that during the 1980s and ‘90s, stocks and bonds were rewarding investors with generous returns. With their portfolios steadily increasing in value year after year, affluent households didn’t need to save as much of their income to see their wealth increase.

Salaries have been rising, especially among the highest-paid executives in the corporate world. When people get used to continuous increases in their incomes, they feel less need to save, and are more likely to spend what they earn, according to economists. Why save 15 percent of this year’s income when you’ll probably earn an extra 15 percent next year?

Credit is so easy to get today that there’s less anxiety about running short of cash in the future. Research by the Federal Reserve concluded that people are probably saving less for a rainy day because they believe they can always borrow money if they need it.

Now that we’ve looked at why household savings are falling, and why mortgage debt is on the rise, let’s look ahead to the future:

First, we forecast that the household savings rates will reverse the current trend and will rise in coming years. Though the stock market will improve, we can’t expect that the equity or bond markets will perform as phenomenally as they did in the 1980s and ‘90s. To supplement their returns from these investments, people will have to save more money from their income in order to build wealth.

Second, expect to see the savings rate increase among the households that earn the top 20 percent of the incomes. While credit will continue to remain readily available ? and thereby give households a way to avoid saving ? we’re likely too see a shift in relative income flows across the wealth spectrum. So far, all of the improvements in productivity have occurred at a faster pace than wage increases for employees. Salaries have risen more rapidly for top managers and, as we’ve discussed, the highest earners have cut back on their savings, possibly because they expect to keep earning more increases every year. But eventually, employees will start to earn higher wages to recognize their higher productivity, and they will be more inclined to save less as a result. At the same time, the tightening gap between the salaries of managers and employees will discourage managers from spending so freely, and their savings should increase.

Third, the increase in household debt will not lead to an economic disaster. As we’ve noted, consumers have exploited low-interest mortgage and home equity loans, while keeping their high-interest credit-card debt in check. At some point, the increases in interest rates will curb consumer spending that was fueled by refinancings. But we shouldn’t expect to see millions of homeowners default on mortgages because they can’t afford to pay rising interest rates on adjustable rate mortgages. Surely, some homeowners have overextended themselves, but that is always the case. Currently, four of every five mortgages are fixed rate loans, and most of those were locked in at historically low rates. Therefore, household debt does not appear to present a long-term threat to the health of the U.S. economy.

References List :
1. To access Milton Ezrati’s article on household debt, visit the Lord, Abbett & Co. website at:www.lordabbett.com/insights/household_debt.pdf