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Forgive Us Our Trespasses?
The Rise of Consumer Debt in Modern America

(Released February 2009)

 
  by Matthew Ruben  

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The previous section offered some measure of detail about the characteristics of the consumer credit market, and about consumer debt in general. This section investigates the characteristics of existing consumer debt, how frequently debt becomes a significant problem for consumers, and which households are suffering the most.

Identifying the Signs of 'Bad' Debt

A number of trends suggest that a growing portion of consumer debt is particularly undesirable. Americans spent more than they saved in 2005 for the first time since the Great Depression.
woman with pile of bills
Bankruptcies and foreclosures are obvious signs of consumer debt problems; these rise and fall as households face obligations they are unable to handle. Foreclosure rates in the housing market have skyrocketed since 2006, and between 1987 and 2007 the number of personal bankruptcy filings in the US quadrupled. (Lopes 769) As of 2005, the US had the highest bankruptcy rate in the world. (Erasmus and Lebani 212) Measuring the number of bankruptcies since then has been made harder by the Bankruptcy Abuse Prevention and Consumer Protection Act, which made it more difficult and expensive for individuals to file starting in October 2005. But since the legislation was put into effect, bankruptcies have steadily climbed again, and at the end of 2008 their frequency is nearly to the point where new cases are being filed at the rate prior to the bill.

But these are by no means the only signs of undesirable consumer debt. From the standpoint of the consumer, other examples include loans with excessively high interest rates and late payment fees, and loans not facilitating future economic benefits.

One sign of relative distress is the growth of credit card debt. From 1989 to 2006, Americans' overall credit card debt grew by 315 percent, from $211 billion to $876 billion (in 2006 dollars). (Garcia 2007, 1) In other words, the percentage increase in credit card debt over this period exceeds the corresponding growth in overall consumer debt. And most households with credit cards now choose to revolve some of the balance due each month. Nearly six in ten households using credit cards revolved their balances in 2004 (choosing to pay interest rather than paying off the debt), with an average balance of $5,219. (Garcia 2007, 1) For lower income households using credit cards, the situation is bleaker, with an average balance of $6,500 for those with incomes below $35,000. (Draut A26)

This debt is particularly bad news for consumers because interest on credit card balances tends to be high. Entering 2009, the average consumer credit card interest rate exceeded 14 percent. Moreover, credit card interest rates are generally higher for households that carry a balance. One-third of cardholders are paying interest rates in excess of 20 percent. (Wheary and Draut 1)

There are other signs of general distress. A report found that between 1993 and 2004, the average debt for seniors graduating from college with student loans more than doubled, far outpacing inflation and cost of living increases over the same period. (Swarthout 2006) Perhaps more importantly, students are more often unable to pay rising tuition with the federal student loan program alone, so they are turning to private student loans. Since 1998, these once-uncommon private student loans have grown 894 percent to $77 billion, accounting for a quarter of all student loans, but "unlike federal student loans which have a fixed interest rate of 6.8 percent, private student loans are typically variable rate loans, with higher starting interest rates and costly origination fees." (Garcia 2008, 7) The implication of the opening of this private market is that while student loans continue to offer the same dividends to consumers (the benefits of a higher education degree), the cost of obtaining the degree is rising.

It is also worth noting that debt levels have risen the fastest for middle class families. Since the 1980s, income levels have grown for middle class families, but not at a rate equal to that of wealthier families. And because their income levels tend to be high enough to offer greater access to credit, middle income families have been more likely than poor families to accumulate a large amount of debt. The debt-to-income ratio for middle class families is higher than that of lower income families (who have less access to credit) and higher than that of upper income families (who have more income and are more easily able to pay off debt). And whereas the median debt-to-income ratio for middle income families was 0.45 in 1983 and 0.54 in 1992, it jumped to 1.19 by 2004. (Pew Research Center 156)

Poverty and the Debt Trap

neon lights advertise payday loans
While debt levels have risen fastest for middle class families, low- and moderate-income families with debt problems suffer disproportionately. With these families already hindered by modest incomes, risk-based pricing further stacks the deck. Risk-based pricing is a methodology adopted by many lenders that measures risk by the lender's estimate of the probability that the borrower will default. Because low-income families are seen as more likely to default, they face higher interest rates, which makes it more difficult for the borrower to pay back the loan. These philosophies hold for other forms of credit as well. Individuals with lower credit scores - usually resulting from late payments or high balances - tend to be stuck with higher interest rates (if they are offered additional credit at all). As one analyst explains, "once people take on debt, the credit card companies react by doing at least one of the following: (1) increase interest rates; (2) charge fees/penalties; and (3) increase credit limits; all of these actions help to raise the likelihood a debtor will not pay off their debt quickly." (Scott 569)

The challenge to pay back the interest on a loan, other possible fees, as well as the principal, all while contending with a higher interest rate (and a smaller income), is the so-called "debt trap" that many low-income households face. If they are unable to pay back the principal on a loan, they may be subject to more fees and an even greater rate hike. If interest rates and fees are particularly high, the trap is made that much more difficult to escape.

Evidence supports the idea that these groups suffer greatly when they take on any form of debt. In 2004, one study calculated that 46 percent of very low-income (under $10,000 per year) households with some credit card debt spent more than 40 percent of their income to pay off debt. (Garcia 2007, 1)

It is also estimated that more people with bad credit are resorting to alternative sources of credit, including payday loans. Credit card interest rates are high, but not nearly as high as payday loan interest rates. Consequently, most consumers resort to payday loans as a last resort. One research study of borrowers from payday loan operations found that "nearly all" have used other types of consumer credit, but were much more likely to be burdened with debt or denied credit. (Stegman 173)

These types of loans amount to an even more daunting debt trap, given that the fees and interest are exponentially higher than in the credit card industry. Making matters worse, payday loan borrowers can't build a credit rating at all, let alone save money. But payday loans have grown dramatically, from an estimated $8 billion in 1999 to between $40 and $50 billion in 2004. (Stegman 170)

Studies of payday lending exemplify the "debt trap." A Portland study found that 74 percent of borrowers were unable to repay their payday loan when due. (Callahan and Mierzwinski 4) Another study done by the Center for Responsible Lending found that the average payday loan is renewed eight times, costing the borrower about $800 for an initial loan of $325. (Draut A26) Yet another finding, from analysis of payday lending in Wisconsin, reports that 53% of payday loans are rollovers. (Stegman and Faris 2008, 20) And these statistics, while striking, might be underestimating the magnitude of the problem, because consumers can pay off one payday loan with another from a different lender.

Go To The Credit Market & Consumer Decisions to Take on Debt

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