Risky And Costly Consumer Debt Could Strain Already Struggling Families

Mutual Funds

Talk about going in the wrong direction. As the U.S. Senate dithers on additional help for struggling families in the recession, Treasury Secretary Mnuchin suggested that families should get a loan to tide them over. Never mind that this sentiment is tone deaf. It also completely ignores the reality that families are already deeply in debt. Any new debt would likely be high-interest loans from credit cards and payday lenders.

Families still carry a lot of debt from the last debt boom. Massive amounts of household debt caused the Great Recession and slowed the recovery. Much of that debt declined during and after the Great Recession, often via painful foreclosures and personal bankruptcies. Yet, debt has remained high. In March 2020, the average American household still owed 95.6% of their after-tax income in mortgages, student loans, car loans and credit cards, to name the most widespread forms of debt (see figure below). Households already had a lot debt as the current recession began.

The overall number, though, doesn’t tell the whole story. Debt has become riskier and costlier for households. Mortgages, which often carry lower interest rates and could be tax deductible, declined amid the housing market crash that started in 2007. In December 2007, mortgages, including home equity lines of credit, averaged 99.7% of after-tax income for all households. This average dropped to 63.7% of after-tax income in March 2020. In comparison, student and car loans, which carry higher interest rates than mortgages, increased from a low of 14.5% of after-tax income in June 2010 to an average of 18.4% in March 2020. Families couldn’t access mortgage debt as easily as before, but they borrowed elsewhere. Debt continued to be a crucial lifeline for families as the costs of education, housing and health care continued to outpace often stagnant incomes.

The current recession will likely force families deeper into costly debt as banks tighten their lending criteria. In April 2020, at the beginning of the pandemic, 38.5% of banks said that they are tightening standards for credit cards, 16.0% for car loans and 21.8% for all consumer loans outside of credit cards and car loans. And the share of banks willing to make installment loans dropped by 20.0% in April. Debt is becoming harder to get, even as households likely will need more of it. Lack of access to debt through banks could lead some people to resort to high interest loans, like payday loans.

More debt is often the only reserve left for struggling households. Job losses mounted as the economy shut down to combat the novel and sometimes deadly virus, but many families have few emergency savings to use to pay their bills upon a loss of income. A Federal Reserve survey showed that 36% of Americans could not access $400 in an emergency in April, even as families expected stimulus payments and added unemployment insurance benefits at the time. Among people with job losses or reduced hours, this share was a much higher 54%. People’s finances have only gotten worse as the deep recession takes its toll on employment and incomes.

Black households, in particular, strain more under costly consumer debt than either Latinx or white households do. Estimates based on the Federal Reserve’s Distributional Financial Accounts show that, on average, African-American families owed $8,870 in consumer loans – credit cards, student debt and auto loans – in March 2020, compared to an average of $4,233 in consumer credit among Latinx households. White families owed a lot more than either Black or Latinx families, with an average of $32,609, but they also had a lot more assets to offset that debt. The ratio of consumer debt to all consumer durables, which include cars, boats, and refrigerators, but not houses, gives a sense of how easily households could get rid of their debt by selling off their assets. That ratio was 139.9% for Black  households and 99.9% for Latinx households, but only 58.7% for white households. That is, white families could sell less than two-thirds of their belongings and have enough money to get rid of all their consumer debt. On the other hand, Latinx families would need to sell all of their consumer durables to eliminate debt from credit cards, student loans, and auto loans, while Black families could sell off all their belongings and would still owe more than one-third of their consumer debt. This suggests that consumer loans are most likely to endanger the financial security of people who are already most likely to experience job losses and least likely to have emergency savings.

Small signs have emerged that households indeed went deeper into debt again to pay their bills as the recession continued. Student and car loans increased at an annual rate of 2.3% in May 2020 after falling by 4.6% in April 2020, according to data from the Federal Reserve.

Many families could end up deeper in debt soon. In July 2020, estimates based on Census data show 24.1% of people who were out of work, because they lost their jobs or were furloughed, borrowed money via credit cards and other loans. Furthermore, 23.8% of those who took on such debt while out of a job also borrowed money from friends and family. Receiving unemployment insurance checks doesn’t necessarily prevent people from needing to incur additional debt while out of work, as 20.7% of unemployed people who got these checks also borrowed money in July. Financial support from the federal government, family, and friends was not enough to keep many families from having to go deeper into debt during the pandemic. As the recession continues, many households will undoubtedly feel even more pressure to borrow money to pay their bills. That pressure will grow now that Congress has failed to extend the added unemployment insurance benefits.

With banks becoming less and less willing to lend, people will need to turn to more easily available credit to stay afloat during the recession. This could include higher interest rate and less regulated and thus riskier debt. More debt, especially riskier and costlier debt, is not the solution that struggling households need. What they need is more income.

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