Saturday, May 19, 2007

Brookings on Low-Income Debt Patterns

by Tanta on 5/19/2007 09:57:00 AM

Borrowing to Get Ahead, and Behind: The Credit Boom and Bust in Lower-Income Markets” is a new paper by Matt Fellowes and Mia Mabanta of the Brookings Institution. It uses Federal Reserve and credit repository data to look at credit usage, total debt levels, and credit delinquency among the poorest quartile of households in 50 metropolitan areas. Although in some cases the paper raises more questions than it answers, it does provide some base data for questioning the wisdom of “ownership society” initiatives justified by the claim that owning is always and everywhere a better deal for the poor than renting.

I was struck by the data regarding debt management:

Still, while the vast majority of lower-income households are managing credit just fine, there is at the same time a large, relative share of lower-income borrowers who are struggling to manage their debt. This is indicated by at least two credit trends that set lower-income borrowers apart from other borrowers. First, lower-income households are highly leveraged. In fact, about 27 percent of lower-income families are now paying more than 40 percent of their income on debt payments—a dramatically higher proportion of households compared to those with a higher income. In fact, among the second income quartile, 15 percent of families pay these high debt-to-income ratios;
about 10 percent within the third quartile; and just 3 percent of the top income quartile. With such high debt service obligations, these 27 percent of lower-income borrowers face greater difficulty saving for additional investments and paying bills on time.

Second, lower-income borrowers are much more likely to fall behind on payments compared to higher-income borrowers. In fact, about one out of every three lower-income borrowers (33 percent) reported in 2004 that they have trouble making payments on time. In contrast, between 22 and 25 percent of borrowers in the second and third income quartiles, fell behind on payments; and just 10 percent of borrowers in the top income quartile fell behind on credit payments in 2004. . . .
To put that into some perspective, 55% of bottom quartile households and 89% of top quartile households had debt in 2004. I have to say the figures on “falling behind” in the middle quartiles—in 2004, while credit costs were still quite low and MEW was running at records—are at least as startling as the figures for low incomes.

This study also throws some cold water on the assumption that increased supply of mortgage credit to lower-income households is primarily a phenomenon of the bubbliest markets:
Differences in the costs of living across areas are a second major influence on the amount of debt held by the typical borrower. Where there are higher costs of living, borrowers in lower-income markets tend to borrow less compared to borrowers living in more affordable areas of the country. This is an important indication of how markets, not just the behavior or characteristics of borrowers, can regulate borrowing behavior. Places that are cheaper to live also afford more opportunities for people to borrow, because goods and services are more affordable, and because borrowers in these areas likely have more disposable income to spend on down-payments for credit-backed goods. Variable housing affordability is one sign of how this is so. Houses in relatively low-cost areas like Jacksonville and Indianapolis, for instance, are much more affordable than in expensive places like New York and San Jose, leading to sharp differences in homeownership rates. That is reflected by the systematically higher median debt held by borrowers from lower-income neighborhoods in low cost places like Jacksonville and Indianapolis compared to their higher cost peers.

But, it is not just mortgage debt that drives up the amount of debt held in more affordable areas of the country: median, non-mortgage debt is also higher in these low cost areas. What does cost of living have to do with those differences? For one, greater home buying rates in the lower cost areas of the country also likely produces higher relative demand for installment loans to buy appliances—costs that are less likely to be directly incurred by renters. Similarly, savings for downpayments to buy other credit-backed goods—like cars, consumer electronics, and furniture—are easier to accumulate when costs of living are low. This suggests that market differences can be nearly as an important influence on credit behavior as the decisions made by borrowers and lenders.
Fellowes and Mabanta conclude with a serious challenge to the idea that lower-income families are winning the bet via highly-leveraged and expensive debt:
While increased lending expanded the spending power and asset ownership in lower income markets, over one-third of lower-income borrowers now struggle to manage debt. Similarly, over one-fourth of lower-income borrowers now devote at least $4 out of every $10 earned for debt payments, pointing to the highly leveraged position of a wide number of lower income borrowers.

Lower-income households are faced with that relatively heavy debt burden mostly because of increased borrowing for mortgages, and installment trades tied to homeownership, like loans for furniture and appliances. In fact, homeownership-related debt accounts for about $7 out of every $10 owed by lower-income families, and is the fastest growing type of debt held by lower-income families.

Other trades, particularly credit cards, represent a very small share of the overall debt held by lower-income families. In fact, this paper finds that credit card debt represents just 6 percent of all debt held by lower-income households. While that is a higher proportion of credit card debt to all debt than exists at higher-income brackets, home equity borrowing among lower-income households—a source of debt widely used for purposes similar to credit cards—represents a much lower share of debt owed by lower-income households compared to all other households.

To meaningfully bring down the amount of debt owed by lower-income households, the unusually high debt service payments they are now burdened with, and the extremely high delinquency rates in some of these markets, policymakers will thus have to put an emphasis on homeownership-related debt—a type of debt that is heavily promoted by government policies. To be sure, this goal of expanding homeownership in lower-income markets should be reexamined, and not just because of evidence that debt has become such a dominating, and too often unsustainable, share of household expenditures among lower-income consumers. Evidence cited earlier also suggests that homeownership may not be a wise decision for every person that qualifies for credit, which suggests a more measured, even cautious, approach to homeownership-boosting initiatives than often exists. Mortgages do substitute for rent, but transaction costs, short holding periods, market downturns, home upkeep costs (i.e., repairing and replacing appliances) and interest-only and other exotic mortgages all can make homeownership a more expensive form of renting.