Monday, April 12, 2010

The interest rate threat on US household debt servicing

One of the less discussed medium-term concerns for the US economy comes from the possibility of a steep rise in the debt servicing burdens of debt-ridden households as interest rates inevitably rise in the months ahead.

As the graphic below shows, despite the steep rise in household debt (which has risen much faster than income, especially in the last decade) over the last thirty years, the household debt service costs have been kept at more or less same levels by a steady decline in interest rates.

Now with rate increases looking inevitable and long-term bond yields slowly hardening, the American households could face a long period of pain if the economy does not expand fast enough to generate income growth that offsets the increased debt service costs. The Office of Management and Budget expects the rate on the benchmark 10-year United States Treasury note to remain close to 3.9% for the rest of the year, but then rise to 4.5% in 2011 and 5% in 2012.

For example, it is estimated that each increase of 1 percentage point in mortgage rates adds as much as 19% to the total cost of a home. The average interest rate on credit cards reached 14.26% in February, up from 12.03% when rates bottomed in the fourth quarter of 2008 — a jump that amounts to about $200 a year in additional interest payments for the typical American household. Many car loans have already become significantly more expensive, with rates at auto finance companies rising to 4.72% in February from 3.26% in December.

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