Consumer Debt and Credit Quality: Can Consumers Weather the COVID Storm?

Key Takeaways

  • With over 26 million people filing initial unemployment claims between March 16 and April 18, 2020, many workers have lost all or a portion of their regular income and have a reduced ability to meet their debt obligations.
  • While the current economic crisis has no direct parallel in recent years, it appears that homeowners, in particular, are better positioned to weather the current crisis than they were at the end of 2007 when the Great Recession began. This may be, in part, due to lessons learned and more strict credit standards for mortgage borrowing.
  • The outlook may be less hopeful for automobile and student loan borrowers:
    • A substantial portion of automobile loans are considered subprime and have a higher risk of default.
    • There appears to be substantial risk in the student loan sector, where default rates have been higher for several years. Student debt is a substantial portion of the debt burden for young workers, and these workers typically have less savings and may be more vulnerable to delinquency and default due to job loss.

Background

Over 26 million people filed initial unemployment claims between March 16, 2020 and April 18, 2020. As businesses scale back operations or close, job losses continue to mount and there is considerable uncertainty around the potential consequences for consumers and their ability to meet their financial obligations. In China, where COVID-19 struck first, delinquencies (late payments) and defaults on consumer debt have surged.[1] While the Coronavirus, Aid, Relief, and Economic Security (CARES) Act, signed by the President on March 27, 2020, provides some relief through income support and the ability to seek leniency from lenders, it is unclear whether it will be enough to help millions of struggling workers pay their bills.

Consumer Debt

Consumers borrow from financial institutions through mortgages, automobile loans, credit cards, student loans, and other debt obligations. During the Great Recession, the high level and poor quality of the outstanding consumer debt led to burgeoning debt loads for households, defaults, and bankruptcies. Are we in for similar outcomes during the COVID-19 crisis? The answer depends, in part, on our current level of household debt and on borrowers’ ability to make payments on that debt.

Total household debt at the end of 2019 was a staggering $14.15 trillion.[2] As shown in Figure 1, compared to the end of 2007, as we were entering into the Great Recession, total household debt is 14 percent, or $1.8 trillion, higher. Nearly every type of debt has increased—automobile loan debt increased 63 percent and student loan debt increased 175 percent. Credit card balances are up modestly, but it is also interesting to note that consumers have used a slightly lower share of their available credit limit. Meanwhile, mortgage debt, by far the largest single component, increased 5 percent, while home equity credit balances are down by almost half, with less of the available limit being borrowed.

Figure 1

Although the level of household debt has increased since the Great Recession, this does not tell us the whole story about whether consumers are able to service this debt. For example, if household income has increased in step with debt, then households would be no better or worse off in terms of their ability to make payments on their debt. Two measures of households’ ability to meet their debt obligations are the “debt service ratio” and the “financial obligations ratio.” The debt service ratio measures “the share of household after-tax income obligated to debt repayment,” and “is calculated as the ratio of aggregate required debt payments (interest and principal) to aggregate after-tax income.”[3] The financial obligations ratio adds additional recurring obligations—rent, auto leases, homeowners’ insurance, and property taxes.[4] Essentially, both are measures of how much of households’ after-tax income goes to making required payments to service debt obligations. As shown in Figure 2, household debt obligations as a share of their income has declined substantially since the beginning of the Great Recession. Moreover, this decrease is driven primarily by a decline in mortgage debt service obligations, meaning that households are spending less on mortgage payments than they were going into 2008.

Figure 2

Quality of Consumer Mortgage Debt

One of the lessons learned from the Great Recession is that while the amount of debt that is held and the ability to service that debt is important, borrowers’ ability to continue to service the debt in the face of an economic shock is also critical. This relates to the quality of the debt, and since mortgages represent by far the largest share of consumer debt, the ability of homeowners to make mortgage payments will be a critical issue during the current crisis. One way to measure the quality of credit is to use borrower’s credit score. Credit scores range from 300 to 850:

  • Scores above 800 are “exceptional,”
  • 740-799 is “very good,”
  • 670-739 is “good,” and
  • below 670 is considered “fair” or “very poor.”[5]

Credit scores below 670 are considered “subprime.”[6] Figure 3 shows the credit scores of mortgage originations from 2003 through the end of 2019. The loans represented in the red and blue areas would be considered subprime loans.

Figure 3

As Figure 3 shows, in recent years most mortgages were originated by consumers with credit scores above 760 (i.e., very good or exceptional). In fact, in each quarter since the third quarter of 2015 the amount borrowed by consumers with a credit score above 760 has exceeded the amount borrowed by all consumers with lower credit scores. In contrast, in 2007 consumers with credit scores between 720 and 759 account for the most borrowing, with over four times as many borrowers having credit scores below 620 than today. At that time, consumers with credit scores above 760 accounted for only about 28 percent of borrowing. What this means is that consumers initiating mortgages in recent years have substantially lower credit risk than borrowers prior to the Great Recession. This may suggest that the housing market today is in better shape to weather the storm—indeed, this would be welcome news to both homeowners and lenders.

Are There Areas to Look Out For?

While the situation entering the current crisis appears better than 2007 for mortgage holders, the situation is less rosy for other types of debt, particularly automobile and student loans. For example, while only about 8 percent of mortgage loans originated in 2019 were by borrowers with credit scores below 660 (i.e., subprime), 32 percent of automobile loans are considered subprime. The effects of the lower credit quality for these types of loans can be seen by looking at delinquencies. Figure 4 shows the percent of loan balances that are seriously delinquent (i.e., more than 90 days without a payment) for automobile, student, and mortgage loans. As Figure 4 shows, the level of serious delinquencies on automobile and student loans are near their highest level since 2003, with delinquencies on student loans up substantially since 2012. In contrast, about 1 percent of current mortgage balances became seriously delinquent in 2019, near the lowest level observed in the available data.

Figure 4

In terms of demographics, automobile and student loans account for a large share of the debt burden for borrowers in the 18-29 age bracket, as shown in Figure 5. Importantly, these younger borrowers are traditionally more likely to transition into delinquency and serious delinquency than borrowers in other age groups.[7] Although younger workers are more likely to lose their jobs, they are also generally more resilient to job loss than older workers.[8] Of course, that is of little comfort to current creditors.

Defaulting on an automobile loan is different from defaulting on a student loan. Automobile loans are “secured” debt in that if there is a loan default, the car can be repossessed and sold to obtain money that is owed. These loans could also be written off if a borrower files for bankruptcy. Student loans are “unsecured” in that there is no asset that can be sold to obtain funds owed, and these loans generally cannot be written off in a bankruptcy. Most student loans (about 92 percent) are Federal loans.[9] Defaulting on Federal student loans can have serious consequences, including garnishment of wages, withholding Federal tax refunds, and damage to the borrower’s credit rating (which reduces their ability to obtain car loans, credit cards, or a mortgage).[10] Fortunately for Federal loan borrowers, there are several avenues available to help avoid delinquency and default. These include:

  • Alternative payment plans, such as an income-driven repayment plan that adjusts repayment based on income and family size;
  • Deferment or forbearance, which allow borrowers to temporarily suspend payments, but interest continues to accrue; and
  • Forgiveness, where some or all of the loans are forgiven if the borrower works full-time for a specified period of time in certain occupation, such as the Teacher Loan Forgiveness Program and the Public Service Loan Forgiveness Program.[11]

Figure 5

Student Loans and the CARES Act

The student loan debt burden for young people is even more striking given the fact that the reported delinquency rates for student loans likely understate the actual effective delinquency rates “because about half of these loans are currently in deferment, in grace periods or in forbearance and therefore temporarily not in the repayment cycle. This implies that among loans in the repayment cycle delinquency rates are roughly twice as high.”[12] Further, a substantial portion of the delinquencies and defaults in student loans are by borrowers who may be the most susceptible to economic hardships during the current economic crisis. Specifically, there are high rates of default among student loan borrowers who come largely from lower-income families, attend educational institutions with relatively weak educational outcomes (e.g., those who enroll less than full time and are less likely to complete), and have poor labor market outcomes after leaving school, leaving their debt burden high relative to their income.[13] These borrowers accounted for much of the increase in delinquency and defaults after the last recession.

The CARES Act provides relief for most student loan borrowers. Student loan payments are suspended, interest-free, from March 13, 2020 (retroactively) through September 30, 2020.[14] However, as we emerge from the current crisis borrowers may need to turn to alternative measures to avoid delinquency and default. The current measures available outside of the CARES Act may increase the financial strain on these borrowers unless additional assistance is provided.

The Current Downturn

With over 26 million people filing initial unemployment claims between March 16 and April 18, 2020, many workers have lost all or a portion of their regular income and have a reduced ability to meet their debt obligations. While the current economic crisis has no direct parallel in recent years, it appears that homeowners, in particular, are better positioned to weather the current crisis than they were at the end of 2007. This may be, in part, due to lessons learned and more strict credit standards for mortgage borrowing, as evidenced in the higher credit scores for recent borrowers.

The outlook may be less hopeful for automobile and student loan borrowers. A substantial portion of automobile loans are considered subprime and have a higher risk of default. In addition, there appears to be substantial risk in the student loan sector, where default rates have been higher for several years. Student debt is a substantial portion of the debt burden for young workers, and these workers typically have less savings and may be more vulnerable to delinquency and default due to job loss.

Government programs, such as the CARES Act, may help consumers to meet their debt burden. In addition to the measures directed toward student loan borrowers, the additional income provided to consumers may help them stay current in their obligations. In addition, many banks are providing relief to borrowers who are negatively affected by the current crisis, including deferring payments, waiving late fees, suspending foreclosures, and not reporting issues to credit bureau agencies. The ultimate effects of the current crisis on consumers and lenders will only truly be known as events unfold and we see how long it takes for people to eventually return to work.

 

 

References

Federal Reserve Bank of New York, Quarterly Report on Household Debt and Credit, 2019:Q4, Released February 2020

Adam Looney and Constantine Yannelis, “A Crisis in Student Loans? How Changes in the Characteristics of Borrowers and in the Institutions They Attended Contributed to Rising Loan Defaults,” Brookings Papers on Economic Activity, Fall 2015.

Peter Debbaut, Andra Ghent, and Marianna Kudlyak, “Are Young Borrowers Bad Borrowers,” Federal Reserve Bank of Richmond Working Paper Series, June 2014.

Sumit Agarwal, Brent W. Ambrose, and Souphala Chomsisengphet, “Determinants of Automobile Loan Default and Prepayment,” Economic Perspectives, Federal Reserve Bank of Chicago, Third Quarter 2008, pp. 17-28.

Lori G. Kletzer and Robert W. Fairlie, “The Long-Term Costs of Job Displacement for Young Adult Workers,” Industrial and Labor Relations Review, Vol. 56, No. 4, July 2003.

Karen Dynan, Kathleen Johnson, and Karen Pence, “Resent Changes to a Measure of U.S. Household Debt Service,” Federal Reserve Bulletin, October 2003, pp. 417-426.

https://www.bloomberg.com/news/articles/2020-03-29/a-global-consumer-default-wave-is-just-getting-started-in-china

https://www.experian.com/blogs/ask-experian/credit-education/score-basics/what-is-a-good-credit-score/

https://www.experian.com/blogs/ask-experian/what-is-subprime/

https://studentaid.gov/announcements-events/coronavirus

https://www.measureone.com/resources

https://studentaid.gov/manage-loans/default

Data

Federal Reserve Bank of New York, Data Underlying Quarterly Report on Household Debt and Credit.

Federal Reserve Board, Household Debt Service and Financial Obligations Ratios

Citations

[1] https://www.bloomberg.com/news/articles/2020-03-29/a-global-consumer-default-wave-is-just-getting-started-in-china

[2] Federal Reserve Bank of New York, Quarterly Report on Household Debt and Credit, 2019:Q4, Released February 2020 (FRBNY 2019:Q4 Report).

[3] Karen Dynan, Kathleen Johnson, and Karen Pence, “Recent Changes to a Measure of U.S. Household Debt Service,” Federal Reserve Bulletin, October 2003, p. 417.

[4] Ibid.

[5] https://www.experian.com/blogs/ask-experian/credit-education/score-basics/what-is-a-good-credit-score/

[6] https://www.experian.com/blogs/ask-experian/what-is-subprime/

[7] See, for example, Peter Debbaut, Andra Ghent, and Marianna Kudlyak, “Are Young Borrowers Bad Borrowers,” Federal Reserve Bank of Richmond Working Paper Series, June 2014. Notably, this paper finds that although borrowers under 21 are more likely to become delinquent, they are not more likely to default. See also, Sumit Agarwal, Brent W. Ambrose, and Souphala Chomsisengphet, “Determinants of Automobile Loan Default and Prepayment,” Economic Perspectives, Federal Reserve Bank of Chicago, Third Quarter 2008, p. 22.

[8] Lori G. Kletzer and Robert W. Fairlie, “The Long-Term Costs of Job Displacement for Young Adult Workers,” Industrial and Labor Relations Review, Vol. 56, No. 4, July 2003.

[9] https://www.measureone.com/resources

[10] https://studentaid.gov/manage-loans/default

[11] https://www.savingforcollege.com/article/federal-vs-private-student-loans

[12] FRBNY 2019:Q4 Report, fn2.

[13] Adam Looney and Constantine Yannelis, “A Crisis in Student Loans? How Changes in the Characteristics of Borrowers and in the Institutions They Attended Contributed to Rising Loan Defaults,” Brookings Papers on Economic Activity, Fall 2015.

[14] https://studentaid.gov/announcements-events/coronavirus

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