Consumer Debt: What It Is, How It Works, and Pros & Cons

What is consumer debt?

Consumer debt consists of personal debts that are owed as a result of purchasing goods that are used for individual or household consumption. Credit card debt, student loans, auto loans, mortgages, and payday loans are all examples of consumer debt. These stand in contrast to other debts that are used for investments in running a business or debt incurred through government operations.

Understanding consumer debt

Consumer loans can be extended by a bank, the federal government, and credit unions, and are broken down into two categories: revolving debt and non-revolving debt. Revolving debt is paid down on a monthly basis, such as credit cards, whereas non-revolving debt is the loan of a lump sum up front with fixed payments over a defined term. Non-revolving credit usually includes auto loans and school loans.

Advantages and disadvantages of consumer debt

Consumer debt is considered a financially suboptimal means of financing because the interest rates charged on the debt, such as credit card balances, are extremely high when compared to mortgage interest rates. Furthermore, the items purchased typically do not provide a necessary utility and do not appreciate in value, which might justify taking on that debt.

An opposite view is that consumer debt results in increased consumer spending and production, thereby growing the economy, and achieves a smoothing of consumption. For example, people borrow at earlier stages in their lives for education and housing, and then pay down that debt later in life when they are earning higher incomes.

Regardless of the pros and cons, consumer debt in the United States is on the rise due to the ease of obtaining financing matched with the high level of interest rates. As of September 2020, consumer debt was $4.16 trillion, with $3.17 trillion in non-revolving debt and $988.6 billion of revolving debt.

If not managed properly, consumer debt can be financially crushing and adversely impact an individual’s credit score, hindering their ability to borrow in the future.

The consumer leverage ratio

The consumer leverage ratio (CLR) measures the amount of debt that the average American consumer holds, compared with their disposable income. The formula is as follows:

Total household debt is derived from the Federal Reserve’s report, while disposable personal income is reported by the U.S. Bureau of Economic Analysis.

The CLR has been used as a litmus test for the health of the U.S. economy, along with other indicators, such as the stock market, inventory levels, and the unemployment rate.

On an individual level, the consumer leverage ratio is advised to be between 10% and 20% of an individual’s take-home pay. Above 20% is an indicator of urgent debt problems.

Consumer debt and predatory lending

Consumer debt is often associated with predatory lending, broadly defined by the FDIC as “imposing unfair and abusive loan terms on borrowers.”

Predatory lending often targets groups with less access to and understanding of more traditional forms of financing. Predatory lenders can charge unreasonably high interest rates and require significant collateral in the likely event a borrower defaults.

Frequently asked questions

What are the most common forms of consumer debt?

The most common forms of consumer debt include credit card debt, student loans, auto loans, mortgages, and payday loans.

How does consumer debt impact my credit score?

If not managed responsibly, consumer debt can negatively impact your credit score, making it harder to secure future loans or credit with favorable terms.

What is the consumer leverage ratio (CLR) and why is it important?

The CLR measures the amount of debt an average consumer holds compared to their disposable income. It’s important because it can indicate the overall financial health of the economy.

Is there a recommended strategy for managing consumer debt?

Yes, there are several strategies for managing consumer debt effectively. These include creating a budget, prioritizing high-interest debts, making consistent payments, and considering debt consolidation or refinancing options. It’s essential to assess your financial situation and choose a strategy that aligns with your goals and resources.

What steps should I take if I find myself struggling with consumer debt?

If you’re facing challenges with consumer debt, it’s crucial to take action promptly. Start by contacting your creditors to discuss repayment options, and consider seeking advice from a certified credit counselor. Budgeting, reducing unnecessary expenses, and exploring debt relief programs are also viable steps to regain control of your finances.

Can consumer debt affect my ability to buy a home or a car?

Yes, consumer debt can impact your ability to secure loans for significant purchases like a home or a car. Lenders typically assess your debt-to-income ratio, which includes your existing consumer debt, to determine your creditworthiness. High levels of consumer debt may result in higher interest rates or difficulty obtaining loan approval.

Are there any legal protections against predatory lending?

Yes, there are legal protections against predatory lending practices. Regulations vary by country and region, but many governments have implemented laws to safeguard consumers from unfair lending practices. It’s essential to familiarize yourself with your local consumer protection laws and report any suspicious or abusive lending behavior to the appropriate authorities.

How can I avoid falling into the cycle of payday loans and high-interest credit card debt?

Avoiding the cycle of payday loans and high-interest credit card debt requires careful financial planning. Start by building an emergency fund to cover unexpected expenses, which can reduce the need for payday loans. Additionally, use credit cards responsibly by paying your balance in full each month to avoid accumulating high-interest debt. Educate yourself about financial literacy to make informed decisions and avoid debt traps.