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The Rise of Consumer Debt in Modern America

(Released February 2009)

  by Matthew Ruben  


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Understanding Consumer Debt


The Merits of Debt?

Individual consumers have clear incentives not to be saddled with too much debt. Excessive use of credit can result in an arduous repayment process or bankruptcy. Certain cultures view personal debt as immoral. We tend to see less consumer borrowing in Islamic and Asian countries where cultural biases exist against people saddled with debt.

But is debt intrinsically bad for consumers? Access to credit has long been seen as an important part in ensuring a better quality of life, particularly in the United States. Home loans and similar loans were designed to allow families to buy homes and cars with only a job and a modest down payment. And smaller loans (including credit cards) can be used by consumers as a safety net in case of medical emergency or sudden unemployment. Legitimate forms of credit at reasonable rates are essential to the achievement of the proverbial American dream.

From a macroeconomic standpoint, consumer credit in the form of low interest rates can help fuel an economy. Since the New Deal, Keynesian economics has promoted greater consumer access to credit, especially during periods of economic decline, in order to increase demand for goods. In other words, when credit is made more available, resulting increases in demands for consumer goods cause an increase in economic production. Consumer spending is the engine of the American economy, and an increase in household debt can be a net benefit for business conditions. In these respects, some level of consumer debt is a healthy and essential ingredient for a modern capitalist economy.

rows of credit cards

Furthermore, an extensive investigation of historical trends in U.S. consumer behavior finds that as consumer debt has grown since the Great Depression, it has done so in large part because of efforts to promote lending as well as to democratize the lending market. If debt is rising, it's doing so because credit opportunities are expanding. New Deal legislation facilitated the greater availability of guaranteed loans for mortgages, home improvements and cars. The innovations of store credit and credit cards in the 1960s and 1970s further improved access to credit. And, while women and minority groups had been excluded from credit in the post-World War II period, public policy efforts in the 1960s and 1970s provided access to these groups. (Logemann, 528)

Therefore, both a sensibility about debt and an understanding of historical trends in this country would justify a steadily climbing rate of consumer debt in the latter half of the 20th Century. Some amount of debt is justifiable. But at what point is there too much debt?

From the standpoint of the individual consumer, "too much" is when debt becomes unmanageable and unpayable. Based on statistics from the Federal Reserve Board, disposable income used to make monthly debt payments hovered between 10 and 12 percent between 1980 and 2000, but, following a period of low interest rates, climbed to more than 14 percent by 2006. (Mantel, 196) But does this suggest households are necessarily having a more difficult time servicing their debt?

From the standpoint of the greater economy, "too much" is when debt is high enough that low interest rates aren't adequate to induce further consumption, or when consumers are saddled with too much debt to invest. Furthermore, when delinquencies and bankruptcies become rampant, as was the case in 2008, banks, other lenders, and markets suffer.

Finally, some forms of debt are unhealthy no matter the level of borrowing. Any predatory lending or usury is undesirable, from the standpoint of both the borrower as well as the economy as a whole.

Not One-Size-Fits-All

From the standpoint of the borrower, there is always a cost to borrowing, and all debt is taken on because of a desired or needed benefit in return. But not all debt is the same. This section falls short of providing a comprehensive look at the various dimensions of consumer debt. But it does offer an overview of how consumer debt can vary greatly in terms of what sort of benefit it can provide and what kind of risks or costs it entails, particularly among the more common forms of debt.

Mortgages and other secured debt

A secured loan is a loan for which the lender receives collateral in return. Mortgages and car loans are among the most common secured loans. In these cases, collateral is provided to the lending institution in the form of a lien on the title to the property until the loan is paid off in full, and if the borrower defaults on the loan, the lender retains the legal right to repossess the property.

Traditionally (though not always), these types of loans - and mortgages in particular - are offered at a lower interest rates because banks and other lending institutions are taking on less risk, thanks to the provided collateral.

Another factor that makes these loans somewhat more desirable is in the real long-term benefit provided to the borrower. The property provided as a result of the loan is a tangible asset that often provides an economic benefit, such as a place to live or a car to drive. (Although while cars tend to rapidly depreciate, houses tend to retain their economic value.) Of course, a loan taken out to purchase goods which don't provide the same sort of economic benefit in the long run - such as an entertainment system - can also be a secured loan. But many secured loans can be justified by their potentially significant long-term economic benefit to the borrower, and this is no doubt one reason why mortgages are traditionally viewed differently than other forms of consumer debt.

Student loans

Student loans differ from mortgages in that they are usually unsecured loans, meaning that collateral is not provided by the borrower against the provided assets. But because education is associated with higher future incomes, lenders view these loans as less risky than loans of other types, and consumers perceive them as rewarding. Young people who otherwise wouldn't be able to afford higher education gain substantial benefits from student loans in the form of better financial opportunities after earning their degree. So student loan debt is "good" because the borrower is purchasing future earning capability and investing in him- or herself.

In a different sense, student loans are comparable to mortgages in providing an investment in the future. Most workers expect their peak earnings to come later in life. Anticipating higher earnings in future years, consumers can afford to borrow to finance earlier in life and later pay down their debt.

Credit cards

Credit cards are another form of unsecured loan, typically offering higher interest rates than long-term secured loans. Other forms of personal loans exist, but because of the relative ease of owning and using a credit card in modern society, credit card debt has grown dramatically. Credit card borrowing is generally considered undesirable because of its association with high interest rates, especially as debt becomes long-term, and its significance is a consequence of the relative convenience of using a credit card. Interest rates can vary dramatically, depending on the state of the economy or the borrower's credit history, but for the most part, interest rates are higher on credit cards than on other forms of personal debt.

graph of credit card debt
Charts showing U.S. consumer debt. U.S. credit card holders on average increased their debt by nearly 5 percent in the fourth quarter of 2007.

Furthermore, even if we consider that many people use credit cards for basic necessities such as utility bills, food, and shelter, the long term benefit of consumables does not typically match the economic benefit of a mortgage or a student loan.

Payday loans

A payday loan is a small, short-term loan provided to a borrower until his or her next payday. Finance charges on payday loans are as a rule very high, and payday loans are often subject to high fees and penalties, varying somewhat depending on local laws. One big advantage of a payday loan is that it doesn't require a credit check, so people with poor credit can borrow money; all that is required is proof of employment and a checking account. Another advantage is in their relative convenience. Today there are more payday loan and check cashing stores in the US than there are McDonald's, Burger King, Sears, J.C. Penney, and Target stores combined. But fees are translated into an estimated 400 to 1000 percent annual interest. (Stegman 169-170) While most payday loans are designed to be short-term, many roll over into a period longer than a few weeks, resulting in exorbitantly high rates of interest. For these types of loans, lenders take on a moderate amount of risk by avoiding a credit check, but loans are backed by postdated personal checks and employment verification.

Common denominators

There is obviously a great chasm separating a medical student paying off loans that financed her education and a minimum wage earner paying off a credit card bill that was used to buy Christmas gifts. But each is still a form of consumer debt. Moreover, while one form of debt might appear to be more morally justified from the standpoint of either consumer welfare or the general economy, the cost and benefit of any loan depends on the details. This means that a loan is only as good or as bad as its rate of payment and possible associated fees. These fees can, in turn, be high even with collateral, or low even without it.

Therefore, it would be foolhardy to dismiss credit card debt as bad for the consumer or student loans as a necessarily good investment. Student loans can be usurious. Credit card interest rates can be reasonable (and credit cards can be paid back quickly, before any interest is charged). Even home equity loans can be spent by the borrower for just about whatever he or she wishes (including paying off credit card debt). Another way of putting it would be that consumers who take on debt must be careful only to accept debt they can afford to repay.

Additionally, it makes little sense to think of these debts as being distinct, given that when consumers need to borrow, they likely choose among these options. If a consumer can't access a home equity loan or a student loan, there is a better chance he or she might borrow from a credit card. And if credit cards are not a readily available option, a consumer might resort to a payday loan.

For better or worse, Americans have taken on more and more debt - mostly through mortgages and other home loans, but through other forms as well. But just because people have high levels of debt does not mean they can't afford to pay the required interest. While record levels of debt suggest that Americans have accumulated excessive amounts, the greater concerns are these. Are Americans able to pay off their debts? Are they resorting to loans requiring higher interest rates? Are they accumulating debt with future benefits for themselves, or is the record debt more an indication of a desperate struggle to get by?

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