Recent changes to a measure of U.S. household debt service

Federal Reserve Bulletin, Oct, 2003 by Karen Dynan, Kathleen Johnson, Karen Pence

Changes in aggregate household debt in the United States may contain information about the current state of the economy and may influence its future path. When a large share of household income is devoted to debt repayment, households have fewer funds available to purchase goods and services. Households with high debt levels relative to income are also more likely to default on their obligations when they suffer an unanticipated misfortune such as job loss or illness. Thus, when household debt ratios are high and unemployment is rising, lenders may respond to the expected increase in defaults by limiting the availability of credit; this dynamic may further weigh on spending.

An often-used summary measure of household debt is the household debt service ratio (formerly known as the household debt service burden), which the Board of Governors of the Federal Reserve System first published in 1980. (1) This measure, which is intended to capture the share of household after-tax income obligated to debt repayment, is calculated as the ratio of aggregate required debt payments (interest and principal) to aggregate after-tax income.

Changes in the structure and sophistication of financial markets in the past several years appear to have affected household debt service ratios. In the residential mortgage market, lenders have developed products that have broadened the base of household debt by enabling borrowers with impaired credit or limited funds for a down payment to purchase homes. Advances in home equity lending have enabled borrowers to extract equity more easily from their homes through a home equity line of credit or a cash-out refinancing. In the auto finance market, more drivers than in the past are leasing their cars instead of purchasing them, while in the education finance market, market share has shifted from commercial bank loans to government-financed student loans.

Because of such changes in financial markets, Federal Reserve staff undertook a major revision of the debt service ratio (DSR), which had last been revised in 1999. In the current revision, the staff had three goals. The first was to evaluate and update the data sources and the methods used to calculate the DSR. The second was to create a broader measure of household liabilities, the financial obligations ratio (FOR), which added recurring obligations--rent, auto leases, homeowners' insurance, and property taxes--that had not traditionally been included in the calculation of the DSR. The third goal was to analyze the effect of recent mortgage market changes on the debt of homeowners by creating estimates of the FOR for homeowners and renters. The results of these revisions are presented in this article.

Interpretation of the DSR and these revisions is subject to several caveats. First, the DSR is a ratio of minimum debt payments, not total debt, to income. Required monthly payments can differ on loans of the same dollar amount because of differences in maturities and interest rates. Second, the measure is a ratio of two aggregate numbers. This measure expresses the debt service obligations of the population as a whole but not necessarily the obligations of the typical household. (2) Third, what the DSR indicates about the economy is not straightforward because it does not incorporate the intentions or expectations of borrowers. Some households may increase their ratios by borrowing more because they are appropriately optimistic about their future income prospects and their corresponding ability to repay debt. Other households may increase their ratios because they have suffered an unanticipated misfortune that necessitates borrowing to cover their extra expenses. An increase in the DSR indicates good news for the economy in the first example and bad news in the second.

UPDATING SOURCES OF DATA FOR THE DSR

Recent developments in credit markets necessitated changing some sources of the data used to calculate the DSR. Commercial banks' changing role in household credit markets led to replacing a bank-level survey with a household-level survey as the source for the distribution of loan types. In the process of revision, members of the Board staff re-evaluated and updated the data sources for loan maturities and interest rates. Also, changes in the student loan market led to using new sources of data for student loans.

Using a New Source of Nonauto, Nonrevolving Debt Shares

In the calculation of the DSR, aggregate nonauto, nonrevolving debt is split into its component parts--student loans, mobile-home loans, recreational vehicle (RV) and marine loans, and personal loans--because these loans have different interest rates and maturities and so have different amounts of debt service associated with a given increase in debt. (3) In the past, the aggregate was split with shares estimated from the American Bankers Association survey of banks. However, the role of commercial banks in household credit markets has changed, and we have become less confident that banks' distribution of loan types represents the distribution for the credit market as a whole.