Makin' Money

Americans make progress with debt — the hard way

Chris Farrell Jan 19, 2012

We all know Americans are struggling to pay down debts. It’s a national conversation.

Well, they’re making progress, and U.S. households are ahead of the other heavily indebted industrial nations, according to a recent McKinsey Global Institute study. I think the strides taken toward reducing household debt is an underappreciated reason why the U.S. economy is showing signs of upward momentum.

The numbers gathered by McKinsey are striking. For instance, the debt service ratio of U.S. households has dropped down to 11.5. That’s well below the peak of 14.0 percent in the third quarter of 2007. It’s even lower than the ratio was at the start of the bubble, in 2000. (The household debt service ratio is an estimate of the ratio of debt payments to disposable personal income; debt payments consist of payments on mortgages and consumer debt.) You can look at the chart at the top of the page.

Household debt outstanding is down by $584 billion or 4 percent from the end of 2008 through the second quarter of 2011. However, it’s heartbreaking how we cut down on debts. Defaults account for about 70 and 80 percent of the decrease in mortgage debt and consumer credit, respectively. Financial distress is reflected in a majority of the defaults, such as lost jobs and medical emergencies. The statistics can’t capture the mental and emotional toll that comes with reducing debts.

How much further is there to go? The McKinsey consultants guesstimate that the U.S. household is about halfway through the deleveraging process, with another 1 to 2 years ahead of us.

Here’s the kicker, though: the amount of equity extracted from homes is stunning.

Nonetheless, after US consumers finish deleveraging, they probably won’t be as powerful an engine of global growth as they were before the crisis. That’s because home equity loans and cash-out refinancing, which from 2003 to 2007 let US consumers extract $2.2 trillion of equity from their homes — an amount more than twice the size of the US fiscal-stimulus package — will not be available. The refinancing era is over: housing prices have declined, the equity in residential real estate has fallen severely, and lending standards are tighter.

We’re moving slowly, painfully away from an economy powered by consumption, debt and housing to one driven by investment, savings and high-tech gear.

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