Household bank auto finance

Changes in aggregate household debt in the United States may contain information about the current state of the economy and may influence its future path. When a large share of household income is devoted to debt repayment, households have fewer funds available to purchase goods and services. Households with high debt levels relative to income are also more likely to default on their obligations when they suffer an unanticipated misfortune such as job loss or illness. Thus, when household debt ratios are high and unemployment is rising, lenders may respond to the expected increase in defaults by limiting the availability of credit; this dynamic may further weigh on spending.

An often-used summary measure of household debt is the household debt service ratio (formerly known as the household debt service burden), which the Board of Governors of the Federal Reserve System first published in 1980. (1) This measure, which is intended to capture the share of household after-tax income obligated to debt repayment, is calculated as the ratio of aggregate required debt payments (interest and principal) to aggregate after-tax income.

Changes in the structure and sophistication of financial markets in the past several years appear to have affected household debt service ratios. In the residential mortgage market, lenders have developed products that have broadened the base of household debt by enabling borrowers with impaired credit or limited funds for a down payment to purchase homes. Advances in home equity lending have enabled borrowers to extract equity more easily from their homes through a home equity line of credit or a cash-out refinancing. In the auto finance market, more drivers than in the past are leasing their cars instead of purchasing them, while in the education finance market, market share has shifted from commercial bank loans to government-financed student loans.

Because of such changes in financial markets, Federal Reserve staff undertook a major revision of the debt service ratio (DSR), which had last been revised in 1999. In the current revision, the staff had three goals. The first was to evaluate and update the data sources and the methods used to calculate the DSR. The second was to create a broader measure of household liabilities, the financial obligations ratio (FOR), which added recurring obligations--rent, auto leases, homeowners' insurance, and property taxes--that had not traditionally been included in the calculation of the DSR. The third goal was to analyze the effect of recent mortgage market changes on the debt of homeowners by creating estimates of the FOR for homeowners and renters. The results of these revisions are presented in this article.

Interpretation of the DSR and these revisions is subject to several caveats. First, the DSR is a ratio of minimum debt payments, not total debt, to income. Required monthly payments can differ on loans of the same dollar amount because of differences in maturities and interest rates. Second, the measure is a ratio of two aggregate numbers. This measure expresses the debt service obligations of the population as a whole but not necessarily the obligations of the typical household. (2) Third, what the DSR indicates about the economy is not straightforward because it does not incorporate the intentions or expectations of borrowers. Some households may increase their ratios by borrowing more because they are appropriately optimistic about their future income prospects and their corresponding ability to repay debt. Other households may increase their ratios because they have suffered an unanticipated misfortune that necessitates borrowing to cover their extra expenses. An increase in the DSR indicates good news for the economy in the first example and bad news in the second.

UPDATING SOURCES OF DATA FOR THE DSR

Recent developments in credit markets necessitated changing some sources of the data used to calculate the DSR. Commercial banks' changing role in household credit markets led to replacing a bank-level survey with a household-level survey as the source for the distribution of loan types. In the process of revision, members of the Board staff re-evaluated and updated the data sources for loan maturities and interest rates. Also, changes in the student loan market led to using new sources of data for student loans.

Using a New Source of Nonauto, Nonrevolving Debt Shares

In the calculation of the DSR, aggregate nonauto, nonrevolving debt is split into its component parts--student loans, mobile-home loans, recreational vehicle (RV) and marine loans, and personal loans--because these loans have different interest rates and maturities and so have different amounts of debt service associated with a given increase in debt. (3) In the past, the aggregate was split with shares estimated from the American Bankers Association survey of banks. However, the role of commercial banks in household credit markets has changed, and we have become less confident that banks' distribution of loan types represents the distribution for the credit market as a whole.

One example of the changing role of commercial banks in household credit markets is the student loan market. From 1983 to 2001, student loans as a share of commercial banks' nonauto, nonrevolving loan portfolio--the previous basis for our estimates--declined from 30 percent to 12 percent (table 1). Over the same period, student loans as a share of households' nonauto, nonrevolving debt--the revisedbasis for our estimates--increased from about 28 percent to 58 percent. That these shares show opposite trends implies that households are obtaining education loans from lenders other than commercial banks, such as the federal government.

Another example is the market for personal loans. Between 1983 and 2001, personal loans as a share of commercial banks' nonauto, nonrevolving consumer loan portfolio fluctuated in a wide band around 30 percent. At the same time, personal loans were declining as a share of households' nonauto, nonrevolving credit; in 2001, they made up only 8 percent of such credit, down from 28 percent in 1983. One possibility is that personal loans have been replaced by credit card debt, a type of revolving debt that has more than doubled as a share of total consumer debt in the past two decades.

To obtain information about such markets, we turned to the Survey of Consumer Finances (SCF) (see box). This survey gathers detailed information on households' financial characteristics. Part of this information concerns households' outstanding consumer loans from all types of lenders.

Updating Assumptions about the Time to Maturity

The assumptions about the remaining time to maturity of the loans outstanding (remaining maturity) used to calculate the DSR have been in place for several years and do not capture the recent changes in credit markets. These maturity assumptions have important implications for the DSR calculation because longer-maturity loans have lower payments, all else being equal, whereas shorter-maturity loans have higher payments. The average remaining times to maturity on types of nonrevolving debt other than auto loans are available infrequently and need to be re-evaluated from time to time.

To update the maturity assumptions, we again turned to the SCF.(4) For example, after examining the SCF data and consulting with industry contacts, we raised the assumed remaining maturity for mobile-home loans to 100 months.(5) The SCF data also indicated that the average remaining maturity on personal loans--of 42 months--was much longer than the previously assumed maturity of 16 months, and so we lengthened this maturity assumption as well. Finally, although the SCF's average remaining maturity for student loans currently being paid--at 65 months--is fairly close to our previous assumption of 80 months, payments on a large number of student loans are currently being deferred. According to the SCF, at any given time, payments are not being made on one-quarter to one-half of student loans. To account for the deferral of student loans, we adjusted the stock of loans to reflect only those loans on which payments are currently being made.

Re-evaluating and Updating the Interest Rate Data

We have also re-evaluated and updated the sources of data on interest rates. In the past, we used proxies for interest rates on RV, marine, and mobile-home loans. (6) According to the SCF, however, the interest rates on these loans are similar to each other and to the Federal Reserve's series on the average interest rate offered by banks on 48-month new car loans (see table 2). Thus, we replaced the previously used proxies with this rate, which is 3 to 4 percentage points lower than the proxies we had been using.