Consumer Debt

What Is Consumer Debt?

Consumer debt consists of personal debts that are owed as a result of purchasing goods that are used for individual or household consumption. Credit card debt, student loans, auto loans, mortgages, and payday loans are all examples of consumer debt. These stand in contrast to other debts that are used for investments in running a business or debt incurred through government operations.

Understanding Consumer Debt

Consumer loans can be extended by a bank, the federal government, and credit unions, and are broken down into two categories: revolving debt and non-revolving debt. Revolving debt is paid down on a monthly basis, such as credit cards, whereas non-revolving debt is the loan of a lump sum up front with fixed payments over a defined term. Non-revolving credit usually includes auto loans and school loans.

Advantages and Disadvantages of Consumer Debt

Consumer debt is considered a financially suboptimal means of financing because the interest rates charged on the debt, such as credit card balances, are extremely high when compared to mortgage interest rates. Furthermore, the items purchased typically do not provide a necessary utility and do not appreciate in value, which might justify taking on that debt.

An opposite view is that consumer debt results in increased consumer spending and production, thereby growing the economy, and achieves a smoothing of consumption. For example, people borrow at earlier stages in their lives for education and housing, and then pay down that debt later in life when they are earning higher incomes.

When the debt is used for education, it can be viewed as a means to an end. The education allows for better-paying jobs in the future, which creates an upward trajectory for both the individual and the economy.

Regardless of the pros and cons, consumer debt in the United States is on the rise due to the ease of obtaining financing matched with the high level of interest rates. As of September 2020, consumer debt was $4.16 trillion, with $3.17 trillion in non-revolving debt and $988.6 billion of revolving debt. If not managed properly, consumer debt can be financially crushing and adversely impact an individual's credit score, hindering their ability to borrow in the future.

The Consumer Leverage Ratio

The consumer leverage ratio (CLR) measures the amount of debt that the average American consumer holds, compared with their disposable income. The formula is as follows:

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Total household debt is derived from the Federal Reserve’s report, while disposable personal income is reported by the U.S. Bureau of Economic Analysis. The CLR has been used as a litmus test for the health of the U.S. economy, along with other indicators, such as the stock market, inventory levels, and the unemployment rate.

On an individual level, the consumer leverage ratio is advised to be between 10% and 20% of an individual's take-home pay. Above 20% is an indicator of urgent debt problems.

Consumer Debt and Predatory Lending

Consumer debt is often associated with predatory lending, broadly defined by the FDIC as “imposing unfair and abusive loan terms on borrowers." Predatory lending often targets groups with less access to and understanding of more traditional forms of financing. Predatory lenders can charge unreasonably high interest rates and require significant collateral in the likely event a borrower defaults.