We Can't Stop Borrowing: Consumer Debt Soars $201 Billion

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After the financial crisis, we were supposed to have learned our lesson. The press started reporting a great deleveraging, as suddenly sober American consumers began to save more and spend less. However, the great deleveraging was always mythical, as BlackRock pointed out in this blog post.

Mortgage debt did reduce, but it was largely the result of banks writing off bad debt, rather than consumers paying down old balances. And by historic standards, total consumer debt remains high. As a percentage of disposable income, it remains above 100 percent. Before 2002, household debt had never gone above 100 percent.

Last week the Federal Reserve of New York released updated household debt data, showing that total consumer debt has now reached $11.85 trillion, an increase of $201 billion. The biggest growth came from:
  • Auto loans, up $93 billion
  • Student loans, up $78 billion
  • Credit cards, up $25 billion
The increase across all classes of debt should concern us. And the mythical deleveraging is now over, as Americans borrow to finance homes cars, schools and trips to restaurants.

Auto Loans

It is true that automobile purchases dramatically reduced after the 2008 crisis. As a result, there was a lot of pent-up demand that has led to the recent increase in auto purchases and financing. However, as Experian Automotive noted earlier this month, there's a more worrying trend. The average term of auto loans is increasing rapidly. Auto loans with terms of 73 to 84 months are now 29.5 percent of all vehicles financed. That's up from just 9 percent five years ago.

When people walk onto an auto dealership, they generally worry only about the monthly payment. By offering much longer terms, the auto dealers are able to offer much bigger loans while keeping the monthly payment relatively flat. However, automobiles are depreciating assets. When you finance an automobile over a longer term, you end up with less principal reduction in the earlier years. That means borrowers will have to wait longer before they can purchase their next automobile, otherwise many borrowers would be facing a negative equity situation.

Even more concerning is the longer term on used automobiles. The average term of a used car is now 62 months, which means the borrowers will have to keep those cars for years. In a worst case scenario, the car starts to break down while there is still significant negative equity.

Student Loans

As I have written earlier, student loan debt remains a ticking time bomb. In the most recent release from the Fed, we see that 90-plus delinquency remains above 11 percent. And total student loan debt has now reached $1.2 trillion, second only to mortgages.

It usually takes a while for true delinquency numbers to catch up with portfolio growth. Over half of the student loan debt outstanding is still not yet in repayment. As more students graduate with student loan debt, we can expect to see the delinquencies and defaults increase.

Credit Cards

Mortgages finance the purchase of a home, which can be an appreciating asset. Student loans finance a college education, which can help enhance lifetime earning potential. Auto loans finance a depreciating asset, but it is a necessity in most of America for work and education. Credit cards, however, are an extremely high cost ways of borrowing money for everyday expenses. They are also used to finance luxuries that we can't afford. Credit cards regularly charge an interest rate higher than 15 percent.

It isn't a surprise to see credit card businesses expanding aggressively. It is now possible to earn unlimited 2 percent cash back. You can easily obtain 40,000 bonus miles if you sign up for a frequent flier credit card. And if you have a less than perfect credit score, credit card companies are increasingly accepting you. The risk tolerance of credit card companies is expanding, as they look to continue generating strong returns.

In the face of this marketing onslaught, Americans of post-2008 are starting to resemble the Americans of before 2008. We continue to open millions of new credit cards every month. And now balances are starting to grow as we use these cards. I expect that credit card balances will continue to increase.

Dealing With Debt

As the recovery continues, unemployment has been reducing. However, wage growth has been minimal. As credit becomes increasingly available, it is important to keep your fixed costs low, avoid the temptation of credit card debt and find the lowest interest rate for the debt that you have.

The two biggest components of most people's fixed costs are their mortgage and auto payments. I have two simple rules: try to keep your mortgage payment well below 30 percent of your monthly net income. Ideally, it shouldn't be more than 25 percent of your take-home pay. And try to keep the term of your auto loan below 5 years -- and ideally no more than 3 years.

For an automobile, you should ideally be saving for the purchase of a car and pay cash. If you don't have the cash for a car, you can certainly consider financing. Consider a credit union like PenFed, where interest rates are as low as 0.99 percent. Obtain your financing before you walk onto the dealer's lot. By financing your automobile for only three years, you will end up buying much less expensive cars. And that is the point. If you have a family income of $60,000 you shouldn't have $40,000 automobiles sitting in the driveway.

Avoid credit cards for everyday spending. You should only use a credit card if you have the discipline to pay the statement balance in full, every month. If you struggle with budgeting, consider using an app like Level Money. It is one of the best budgeting apps I have found.

And if you have credit card debt, you should look to pay off the debt as quickly as possible. The most important part to paying off credit card debt is setting a written budget and aggressively attacking the debt. You can help speed up debt repayment by refinancing to a lower interest rate. A number of marketplace lenders have been established to offer personal loans. Consider shopping for a lower interest rate using a website like MagnifyMoney (which is my website) or CreditKarma. With marketplace lenders, you can reduce the interest rate on your debt by 30 percent or more.

Yet We Continue To Borrow

There have never been so many tools available to save money. You can use websites like MagnifyMoney to find the lowest interest rates on debt. You can refinance your debt with start-ups like Lending Club, at a much lower interest rate. You can manage your spending with budgeting apps like Level Money. Yet we continue to borrow. All of these tools are great. But what we need is a commitment to stop living beyond our means. It looks like it is going to take more than the 2008 crisis to get us to change.
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