US Consumer Credit Outlook: Focus on Low-Income Borrowers

Aytekin Satiroglu 30 June 2022

The Russia-Ukraine war and supply-chain bottlenecks in China continued to weigh on the US economy as we reached mid-2022. The economic activity slowed down while inflation and interest rates increased. In this article, we first discuss these market developments and present the economic outlook. Later, we examine the implications for consumer credit performance and the distributional effects: arrears and default rates are expected to increase, particularly for low-income borrowers.

Introduction

Consumer prices hit a record high

US Consumer Price Index increased 8.6% from a year ago in May 2022, recording the largest 12-month increase since December 1981 [1]. The Russia-Ukraine war and supply-chain disruptions due to COVID-19 lockdowns in China led to a surge in food and energy prices: 10.1% and 34.6% respectively over the last year (Figure 1).

Price pressures also came from the strong demand due to 1- Low interest rates and support programs during the pandemic, 2- High pent-up savings and demand thereafter, and 3- Worries about the future supply.

Figure 1: US Inflation by Key Categories, May 2022, Percent Change from Year Ago


Figure 1: US Inflation by Key Categories, May 2022, Percent Change from Year Ago
Source: U.S. Bureau of Labor Statistics, retrieved on June 16th 2022

Fed raised the interest rates

To bring down the high rate of inflation, the Fed raised the federal funds rate by 75 bps to a target range of 1.5% to 1.75% in its June meeting [2]. This marked the largest interest rate hike in 28 years and further tightening of financial conditions.

What does this mean for borrowers? Higher cost of borrowing. Interest rates on adjustable-rate mortgages, auto loans and credit cards increase following the Fed’s rate hikes. The cost of new fixed-rate debt increases as well: the average interest rate on a 30-year fixed-rate mortgage rose by more than half a percentage point to 5.78% following the Fed’s decision, to the highest level since November 2008 (5.97%), and recorded the sharpest weekly increase since 1987 [3]. This rate was only 2.98% a year ago from today, and 3.2% at the start of 2022 [4].

Market developments have been far from perfect

After a dramatic rebound of 6.9% in 2021 Q4, the US real GDP fell at a 1.5% annual rate in 2022 Q1 [5]. Consumer sentiment [6] and the share of small businesses expecting better conditions over the next 6 months [7] both fell to historically low levels.

The Fed’s interest rate hike added on top to the existing recession fears stemming from high inflation, prolonged lockdowns in China, and the Russia-Ukraine war. Investors’ risk appetite fell further after Powell called recession “certainly a possibility” [8]. S&P500 dropped 5.8% over the week after the rate decision, extending its losses by over 20% year-to-date [9].

Arrears and default rates are expected to increase

Three main factors point to higher arrears and default rates on consumer loans in the coming months:

Currently the US labor market is tight: The unemployment rate was at a 50-year low level of 3.6% in May 2022 [10]. The unemployment rate, however, increases during and after economic slowdowns: it had reached 10% in the aftermath of the Great Recession and 14.7% after the start of the pandemic.
Inflation will likely stay high and further upside inflation surprises “could be in the store” according to the Fed’s chair [11]. Interest rate hikes might not be able to tame inflation as inflation also depends on the geopolitical and pandemic-related factors that the Fed don’t control. Inflation, particularly in the prices of essentials such as food, energy, and shelter, lowers the borrowers’ income available to repay debt.
Interest rates were increased and “ongoing rate increases will be appropriate” Powell said in his testimony to the Congress [12]. Interest rate hikes increase the amount of adjustable-rate linked debt and hence increase the debt-to-disposable income ratio. It also increases refinancing risks.

Figure 2 illustrates the historical co-movement of these factors with arrears and default rates on consumer loans.

Figure 2: Unemployment, Inflation, Federal Funds Effective Rate vs Charge-Off and Delinquency Rates on Consumer Loans, US


Figure 2: Unemployment, Inflation, Federal Funds Effective Rate vs Charge-Off and Delinquency Rates on Consumer Loans, US.
Source: Board of Governors of the Federal Reserve System (US), retrieved from FRED on June 27th 2022

Low-income borrowers will face more hardship in debt repayments

Aggregate statistics of credit performance mask the disparity between low- and high-income borrowers. Low-income borrowers typically shoulder a larger burden of servicing debt and therefore tend to have higher arrears rates than high-income borrowers.

Figure 3 shows this relationship on a state level: US states with lower per capita disposable income have higher rates of serious delinquency across major credit categories.

Figure 3: Percent of Debt Balance 90+ Delinquent vs Per Capita Disposable Income by US State, 2021


Figure 3: Percent of Debt Balance 90+ Delinquent vs Per Capita Disposable Income by US State, 2021.
Source: U.S. Bureau of Economic Analysis, New York Fed Consumer Credit Panel/Equifax, retrieved on June 24th 2022

Recessions, high inflation, and higher interest rates affect low- and high-income borrowers disproportionately.

A great example is the pandemic-induced recession when the unemployment rate increased to a historically high level of 14.7%. Low-wage workers lost jobs at five times the rate of middle-wage workers, while high-wage employment increased [13]. The high rate of unemployment, however, did not result in higher arrears rates during the pandemic as stimulus programs and repayment moratoria on student loans and mortgages helped borrowers continue debt payments [14]. With the end of the pandemic relief, unemployment might have a more pronounced impact on consumer arrears and default rates, especially for low-income borrowers.
Spending on essential goods constitutes a larger share of total expenditures for lower-income households (Figure 4). As the prices of essential goods increase, low-income households are the ones who face the cost-of-living crisis. Low-income debt holders endure more hardship on their debt repayments than high-income borrowers during inflationary periods since the ability to cut back on essential spending is limited.
Higher interest rates increase the debt burden relatively more for low-income borrowers as they lead to larger increases in debt-to-disposable income ratio compared to high-income borrowers.

Figure 4: Share of Annual Expenditure by Income Quintiles, Key Categories, US, 2020


Figure 4: Share of Annual Expenditure by Income Quintiles, Key Categories, US, 2020.
Source: U.S. Bureau of Labor Statistics – Consumer Expenditure Surveys (2020), retrieved on June 16th 2022

Given the current market conditions, their uneven effects on income groups, and the economic outlook, increases in arrears and default rates are expected to be more significant for low-income borrowers in the coming months.

This could have longer-term impacts as well since higher arrears and default rates eventually feed into lower credit scores and therefore into higher interest rates for low-income borrowers. Access to credit could shrink for low-income borrowers (like after the Great Recession) which could limit their chances of upward mobility and could increase the overall economic inequality.

Conclusion

The US economy is facing headwinds: record-high inflation, contracting real GDP and stock market turmoil. Recession fears are mounting as COVID-19 lockdowns in China and the Russia-Ukraine war continue and are expected to keep inflation elevated. The Fed’s decision to raise interest rates and its signals to continue interest rate hikes are compounding the recession fears.

Arrears and default rates on consumer loans are expected to increase as high inflation erodes borrowers’ incomes available to repay debt, and higher interest rates increase debt balances. Moreover, as the US economy slows down, the unemployment rate could increase, and this could add more pressure on borrowers.

Recessions, high inflation, and higher interest rates have distributional consequences in the short- and long-term. Low-income borrowers are more sensitive to economic downturns than high-income borrowers from unemployment and disposable income perspectives. Therefore, also considering the current market conditions and the economic outlook, low-income borrowers are expected to face more hardship in debt repayments.