Head of Global Economics
BofA Global Research
How will rising rates affect consumer debt?
Investors are getting increasingly concerned about the impact of rising rates on the consumer balance sheet. We estimate that for the average household, debt repayments will increase by around $500 (or 0.35% of disposable income) this year due to rising interest rates. The aggregate impact on the consumer is limited since the majority of consumer debt, including mortgages and auto loans, is subject to fixed rates. That said, the bigger worry comes when more existing loans mature and new originations take place under higher interest rates. This supports our view that the economy will gradually slow and slip below trend next year.
A tale of two mortgages
According to the New York Fed, household debt reached $15.8tn by the end of 1Q 2022. Mortgages account for 70% of total outstanding debt. In order to understand the impact of higher rates on mortgage repayments, we divide mortgages into fixed-rate mortgages (FRMs) and adjustable-rate mortgages (ARMs). We generally view the 30-yr mortgage rate as the sum of the 10-yr Treasury yield and a credit spread. As of this writing, the 10-yr Treasury yield is around 2.8% and our rates strategists are looking for it to climb to 3.25% in 3Q and 4Q of this year. Meanwhile, the spread between the 30-yr mortgage rate and the 10-yr Treasury yield, which averaged ~175bp over the last 30 years, has risen to around 230bp this year.
Based on our strategists’ Treasury yield forecasts some scenarios for the mortgage spread, we estimate that consumers will face between $38-46bn more in additional payments, or $300-$360 per household (there are ~128mn households in the US) for FRMs.
Meanwhile the impact from ARMs will be minimal largely due to their decreasing prevalence. As of March 2022 the share of ARMs in outstanding mortgages was just 1%, which was a drastic decline from 12% right before the Great Financial Crisis. Note that for ARMs, repayments for the first few years are also under a fixed-rate and therefore the floating balance within ARMs is even smaller. Specifically, the current outstanding balance for ARMs that are already in their floating period is just around $26bn.
The bottom line is that most of the impact from higher interest rates will be felt through new originations and the aggregate additional repayments by consumers will amount to between 0.2% and 0.3% of total disposable income.
Auto loans: will the engine slow down?
Auto loan origination saw a noticeable jump in 2021 as surging car prices pushed up borrowing. According to data from Experian, as of 4Q 2021, a majority of auto loans are fixed-rate medium-term loans, while only 8.5% of loans have terms under 48 months. This means that once again, only new originations will be impacted by higher rates.
The aggregate amount of new auto loan originations will be determined by two factors: the number of new loans originated, and the average amount per loan that people are borrowing. The average amount per loan is highly influenced by auto prices, and we expect high single-digit annual 2022 inflation for used and new cars.
Asking for credit
Consumer credit card balances saw a dramatic decrease during the pandemic as consumers paid down debt with increased savings. Between 4Q 2019 and 1Q 2021, credit card balances dropped by 17% to $0.77tn but have since climbed back up to $0.84tn as of 1Q 2022. We assume that credit card balances will grow slightly above trend this year, given resilient consumer demand, particularly for services, as well as elevated inflation. Credit card interest rates for each customer move closely with the “bank prime rate”, which in turn is linked to the fed funds rate. As a result, we estimate that consumer credit card payments will rise by around $84 per household.
Bottom line: no meaningful impact this year
Our estimation suggest that on average, household debt repayments will increase by about $500 (or 0.35% of disposable income) this year due to rising interest rates. Although this only creates a modest shock, consumers will eventually face stiffer headwinds as more existing loans mature and new originations take place under higher interest rates. This supports our view that the economy will gradually slow and slip below trend next year.
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