Rising Consumer Credit Could Pose Risks In Slowing Economy

A strong labor market currently provides households with lots of jobs and rising wages that make it easier to pay off their debt, even as households are borrowing more money, especially on credit cards. Right now, delinquencies on consumer credit are still well below their already fairly low levels before the pandemic. But, this could change if policy risks materialize and the economy and labor market slow. Widespread consumer credit could then pose a risk to people’s financial security and possibly to the economy.

The Federal Reserve reports that consumers continue to borrow money ever more money on credit cards, student loans, auto loans, and other forms of non-mortgage debt. In December 2022, the amount of total consumer debt stood at $4.8 trillion. This is equal to 25.2% of the total amount of after tax income for all Americans. This is still slightly below the record consumer debt amount relative to after-tax income of 25.4% recorded at the end of December 2017, but it is not too far off (see figure below).

Most recently, the growth in consumer debt has come especially from more credit cards. Total credit card debt relative to after-tax income has grown from less than 6% in 2021 to 6.3% in December 2022. It still remains below its pre-pandemic level of 6.6% of after-tax income, though. The sum of other consumer credit to after-tax credit reached a record high of 18.9% in April 2022 and has stayed at that level since then. Importantly, much of the recent growth in consumer credit has come from variable interest rate debt.

People typically take on these types of loans because they have a hard time paying their bills otherwise. They borrow to pay for health care, for a new car that they need to go to work and to cover their expenses as they face an emergency such a family member getting sick. People by and large do not borrow money frivolously. People also borrow money because they have few emergency savings. In fact, the rise in consumer debt has gone along with declining liquid savings after an initial bump associated with pandemic assistance in 2021 and early 2022. The increase in consumer debt then reflects growing financial strains for many households. Consumer debt is the pressure valve when are being squeezed by high costs, low incomes or a combination of both high prices and low incomes. The recent debt growth thus likely reflects people facing high costs, even as the labor market generates lots of new jobs and strong wage gains, especially for lower-wage workers.

As interest rates have gone up, so has the burden of paying back this debt. The Federal Reserve estimates that the average debt service on consumer debt – non-mortgage debt – stood at 5.76% in the third quarter of 2022. This was the highest debt service ratio since the first quarter of 2009.

Right now, people are still well positioned to pay off their debt. The Federal Reserve also estimates that only 1.92% of consumer loans were delinquent – at least 30 days past due and still in payment status. This is much lower than the 2.5% or so before the pandemic. The resilient labor market currently provides people with enough income to manage the extra debt.

There is a flipside to this, though. As people pay larger and larger shares of their incomes to repay their debt, they will have less money to buy other things. This could somewhat slow consumer demand and economic growth. An increase in debt service relative to after-tax income by half a percentage point, which is roughly the size of the increase from the middle of 2021 to late 2022, is equal to about 0.4% of gross domestic product. This is more than the 10% of the current economic growth rate of 2.9%. The economy is strong enough for now, thanks to past policies that helped create a historic and equitable recovery, to withstand this drag on growth.

The mounting debt burden could become a substantial drag on growth if policy risks to the economy materialize, however. After all, if the economy slows, people lose their jobs and wage growth declines, people still need to pay back their debt – and some may need to take out even more debt to make ends meet. The debt burden will go up much faster if income growth slows, even if people slow their borrowing. This could happen if congressional Republicans gamble with the economic recovery continues. Their holding the federal government’s ability to pay its bills hostage creates widespread economic uncertainty that can dampen growth. And, the Federal Reserve’s continued focus on slowing economic growth could also translate into income losses, especially for those households that are most likely to owe a lot consumer debt.

Yet, consumer debt is not equally distributed. Black and Latino households as well as households headed by somebody without a college degree tend to be the ones that owe more in credit card debt, for example, than white households and households headed by somebody with a college degree. The challenges to people’s finances from more consumer debt often impact those who are already financially vulnerable. The gambles that congressional Republicans and the Federal Reserve engage in could thus unravel two major accomplishments from President Biden’s policies – a historic recovery that is also equitably shared – through a number of mechanisms.