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The current economic recovery has relied heavily on households to borrow ever more money to sustain their consumption. Households have taken on ever higher amounts of debt, particularly in the form of mortgage debt and home equity lines. These additional funds have fuelled a surge in residential construction and household consumption, which has propped up economic growth.
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Economic fundamentals suggest that long-term interest rates, such as mortgage rates, are more likely to rise in the coming year than to stay the same or even fall. Upward pressures on interest rates arise from large budget and trade deficits, higher oil prices, and the Federal Reserve’s short-term interest rate increases.
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Households will likely end up paying more in interest payments, even if they do not borrow more. A growing share of household debt is variable interest rate debt: home equity lines, adjustable rate mortgages, and credit card debt.
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Under realistic assumptions, the average household will pay $194-$229 more annually if interest rates rise by 0.5 percentage points and $387-$449 if interest rates rise by 1 percentage point, depending on how much more they will borrow at the same time. This additional burden could be two to three times as large as the additional burden from greater medical out-of-pocket expenditures.
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A higher debt service burden can translate into more financially distressed households. For instance, the estimated share of households filing for bankruptcy has risen for three years in a row.
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The access that households have had to cash through refinancing will have dried up as interest rates rise. If consumer spending on consumption items and on their homes slows down enough, the recovery may lose steam. We estimate that a 1 percentage point increase in interest rates can substantially reduce consumption growth, so that other sectors would have to grow 6-10 percent in inflation adjusted terms just to maintain a basic overall growth rate of 3 percent.
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Public policy should focus on weaning the economy off a debt driven consumption boom and replacing it with income support consumption growth. A number of policy options exist to boost income growth, such as higher minimum wages, improved labor laws to support the efforts of workers to join unions, and improved unemployment insurance.
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