How U.S. Consumers Are Conquering Debt

Some Americans show spending discipline, but others need it forced upon them.

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The behavior of American consumers routinely surprises economists—usually because of their dogged determination to keep spending. But lately they've shown another unexpected trick: Getting rid of debt.

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Excessive debt helped cause the recent recession, and made it worse than it needed to be. Consumers with unaffordable mortgages and bulging credit-card balances defaulted in record numbers, pushing up bank losses and sucking the whole economy into a panic that started in the financial sector. Families that should have had a cushion during the downturn instead found their finances maxed out, with no ability to borrow as a bridge to better times. Banks share much of the blame, of course, for lending to anybody with a pulse and persuading gullible borrowers to take out unmanageable loans. But millions of Americans willingly used debt to live far beyond their means, raising perfectly valid questions about whether U.S. consumers had become the most irresponsible spenders on earth.

Apparently, they're not. Since the beginning of 2008, when the incipient recession began to intensify, U.S. consumers have cut debt more quickly and deeply than many economists thought they were capable of doing. That's a big reason forecasters are increasingly optimistic about the economy, and about the ability of U.S. consumers to keep spending. "Consumers have squarely and significantly addressed their debt problem," says Robert Doll, chief equity strategist for the big investing firm BlackRock. "The balance sheet of the U.S. consumer, while still having some issues, is in much better shape than it was a few years ago." Doll predicts economic growth of about 3.5 percent in 2011, with consumer spending making a healthy rebound.

Overall, the data suggests a newfound discipline among consumers who have been bingeing on debt since the 1980s. The total amount of household debt, including mortgages, credit card balances, and other types of consumer loans, is about $13.9 trillion, down from a peak of $14.4 trillion in 2007. That's just a 1.5 percent decline over three years, but it's also the first time the total amount of household debt has gone down since the end of World War II. And debt has fallen for at least 24 months in a row (the latest data are through the end of September).

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That means Americans are spending less of their disposable income to pay off debt. The debt-to-income ratio, which measures a typical household's debt compared to its annual take-home pay, peaked at about 138 percent in 2007. So for a household with disposable yearly income of $100,000, the debt load was about $138,000, on average. That ratio has since fallen to about 122 percent. That's still too high—for most of the past 65 years, the debt-to-income ratio has been well below 100 percent. But the recent decline is the sharpest on record. Not a bad start, if we're really deleveraging.

The amount of take-home pay dedicated to paying off debt—known as the debt-service ratio—has been falling, too. In 2007, the debt-service ratio peaked at about 14 percent, which means that a household clearing $100,000 in income would devote about $14,000 of that to mortgage, car, credit-card, and other loan payments. (If the percentage seems low, remember that the figures include people who own their homes outright and make no mortgage payments.) The debt-service ratio is now down to about 11.9 percent, which is where it was in the late '90s, before the housing bubble inflated and consumers went berserk. By some estimates, that's a "normal" amount of debt, which suggests that consumers could be primed to resume the lavish spending habits of yore.

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Consumers, however, don't deserve as much credit for self-discipline as it might seem. Part of the reason debt levels and debt payments have fallen is that the Federal Reserve has forced interest rates to record lows, and the Fed is still going to extreme measures (such as quantitative easing) to keep rates depressed. That has allowed millions of home buyers, for example, to refinance their mortgages at lower rates, and pocket found money that offsets some of the losses caused by falling home values. Rates on other types of loans have fallen too, which benefits car buyers, for instance, who trade in a car they're still making payments on for one that takes a smaller bite out of their monthly income. Doll of Blackrock estimates that about 40 percent of the decline in the debt-service ratio is due to lower interest rates, not consumer frugality.

Banks and credit-card issuers have also helped rein in excessive debt, although it doesn't always feel like help to consumers. After being far too loose with credit—and racking up the losses to prove it—lenders have slashed consumer credit lines, refused credit to consumers who would have qualified a few years ago, and canceled some accounts outright. "People can't charge as much as they used to charge," says Bill Hardekopf, CEO of, a credit-card research site. "That's why some of that debt has gone down dramatically."

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Beyond that, many consumers have simply defaulted on mortgages, car loans, and credit-card balances, wiping out the debt. That's not the most advisable way to get rid of debt, but it does enforce spending discipline—especially since most defaulters must go without ordinary credit for several years.

Still, some consumers have clearly been working off debt on their own, without the banks—or a bankruptcy filing—doing it for them. Hardekopf says that average credit-card interest rates have bucked the trend over the last couple of years, with issuers raising rates about two percentage points, to about 14 percent on average, to make up for revenue they've lost in other areas. Some consumers seem to have noticed, and switched to debits cards or cash, especially since the recession made them much more aware of hidden fees and wasted money.

It's hard to tell how much of the improvement in debt levels is due to smarter, thriftier consumers, and how much is due to lenders constricting the flow of money. But for the economy, it doesn't matter that much, since reduced debt means that consumers have sounder finances, no matter why it happened.

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A bigger question is whether the debt reduction will continue, or turn out to be a temporary flash of frugality. Many banks say that with their losses fading and the economy gaining strength, they plan to ease up on lending in the near future. So consumers who have been unable to get a mortgage or a credit-line extension may suddenly qualify, driving debt levels back up. And a strong holiday shopping season in 2010—despite high unemployment and other worries—shows that consumers haven't lost their affinity for the mall. Americans may be gaining control of their debt, but a weak moment or two could allow debt to regain control of them.

Twitter: @rickjnewman