How to Tell If You're Saving Enough

Save or spend? That will be the question that bedevils consumers over the next several years as they replenish their rainy-day funds, rebalance their debt, and limp toward retirement.

It's no secret that Americans spent too much and saved too little over the last decade. For 40 years after World War II, Americans typically saved somewhere between 6 and 10 percent of their after-tax income. The savings rate began to drift down in 1985, and for most of the last five years it's been less than 3 percent. It even dipped below zero in 2005. With frightened consumers now starting to hoard cash (if they have any), the savings rate has inched back up to about 4 percent. But many economists feel that's not high enough.

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While we were saving less we were borrowing more, and now we're dealing with the hangover from that, too. In 1960, the typical U.S. household had debt that equaled about 55 percent of after-tax disposable income. For years, that rose gradually as credit card borrowing, low-down-payment mortgages and other types of easy credit became common. Then, household debt exploded after 2000, peaking at 130 percent of income in early 2008. It's fallen slightly since then, but the typical family still owes more to lenders that it earns in a given year.

How bad off is your family? Here are some figures from the Federal Reserve and from economists at Bank of America Merrill Lynch to help compare your own debt, savings and net worth to national averages:

• The average debt-to-income ratio, or DTI, is 125 percent today. Economists roughly consider a 100 percent DTI ratio to be "normal" or healthy. So if you owed a combined $125,000 on your mortgage, car loans and other obligations and earned $100,000 in take-home pay, you'd want to pay down your debt by $25,000, or 20 percent, to be in the safe zone.

• The average ratio of household net worth to disposable income, or the wealth-to-income ratio, is 487 percent today. That's lower than the average since 1993, which has been about 550 percent. The lost wealth is mainly because of declines in the value of homes and stocks, which is where many people have parked their money. Your net worth is a fairly simple equation: your mortgage balance and other debts and liabilities subtracted from your home equity, investments, and other assets. So you can increase your net worth in two basic ways: Either increasing your assets or lowering your debts.

• The savings rate this year is about 4 percent. One mainstream assumption is that as the savings rate goes up, about 80 percent of new savings will be used to pay down debt, while about 20 percent will be invested in securities or other assets that pay interest.

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Since debt has gone up while net worth has fallen, most economists assume that Americans will revert to historical norms by saving more of their take-home pay and using it to pay off debt, which in turn will raise their net worth. For the typical family, that's a prudent thing to do. But there's a downside: The U.S. economy is dependent on robust, even profligate, spending, and prolonged thrift would depress the consumer spending needed for a return to healthy economic growth. In a study that came out earlier this year, Federal Reserve economists Reuven Glick and Kevin Lansing suggested that the savings rate would have to rise to about 10 percent by 2018 for American households, on average, to lower their debt to reasonable levels. If that happens, they argue, the reduced spending could slice 0.75 percentage points off economic growth every year. Combined with other factors, that lower growth would portend a weak economy, with poor job creation, for the foreseeable future.

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It's possible however, that the savings rate has itself reach a new norm—albeit a low one—and that consumers will rebuild wealth without paying down debt or socking away a huge amount of extra cash. A recent research note by Bank of America Merrill Lynch argues that the typical American consumer doesn't have the discipline to save 10 percent of after-tax income, which is what would be necessary to get household debt back to the normal zone. Instead, the B of A economists argue that Americans care more about their net worth than their debt load and might find ways to rebuild their net worth without paying down debt or ever saving 10 percent of their disposable income.

In one B of A scenario, American households get back to the historic wealth-to-income ratio of 550 percent by saving only about 5 percent of their income over the next decade while making investments that increase their assets and therefore boost their net worth. The catch is that the debt-to-income ratio, instead of falling, would stabilize near the historical high of about 130 percent. In another scenario, households could reach the 550 percent wealth-to-income target with a savings rate that's barely above 4 percent by building up assets and taking on even more debt. But the debt-to-income ratio would soar to 160 percent or more.

There are plenty of variables, of course. As millions of consumers have learned, it's risky to bet your future financial health on an expected return on your investments, and many Americans have lost their tolerance for risk; paying off debt may seem simpler and safer than any other approach. And families will try to rebuild wealth differently based on how close they are to retirement age. Still, for those who can tolerate the risk, debt is appealing because it often helps produce a greater return on every investment dollar. And if inflation rises significantly, as some economists expect, today's debts will be easier to pay off in the future, since earnings typically rise to keep up with inflation while most debt remains fixed.

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Some families couldn't take on more debt if they wanted to, because banks are far less generous with loans these days. But that could ease, and the government might even subtly encourage higher debt levels down the road, since that would allow consumers to spend more and stimulate growth. The ultimate question may be what's less painful for the typical household over the next decade: living with a high long-term debt load, or curtailing spending indefinitely. Economists tend to think that spending will drop to uncharacteristic lows while debt returns to levels more consistent with the past. But it could be the other way around, with spending staying where it's been while we find new ways to accommodate debt. The resourceful American consumer may yet come up with new ways to keep on spending.

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