So I recently came across this Forbes article that highlighted the $17B mountain of household debt American consumers are saddled with as of Q1 2023. I guess we are collectively good representatives of our government 😅. Here's the article if you're curious:
It piqued my interest because I'm launching a product concept that sits squarely in this space. As part of the market research for the launch, I found myself looking quite a bit into consumer spending and and household debt patterns. Furthermore, I think it's interesting to take a look at the advances in open banking technologies that have come about recently and how these advances might influence consumer behavior for better or worse. Digging deeper, here are some interesting stats from the most recent FRED (Federal Reserve Economic Data) reports concerning household debt in the U.S.:
| Income group | Median DTI Ratio | Maximum DTI Ratio | Minimum DTI Ratio | Median Household DSR Ratio | Maximum Household DSR Ratio | Minimum Household DSR Ratio |
|---|---|---|---|---|---|---|
| Below $50,000 | 14.70% | 38.30% | 2.70% | 16.80% | 44.10% | 5.30% |
| $50,000 - $75,000 | 11.80% | 28.80% | 2.50% | 13.70% | 37.50% | 5.10% |
| $75,000 - $100,000 | 9.60% | 23.10% | 1.90% | 11.30% | 28.70% | 4.60% |
| $100,000 - $150,000 | 8.10% | 19.50% | 1.50% | 10.00% | 25.20% | 4.10% |
| Above $150,000 | 6.90% | 16.20% | 1.10% | 8.90% | 21.40% | 3.60% |
A few quick definitions are in order:
Debt-to-income (DTI) ratio and debt service ratio (DSR) are both measures of a borrower's ability to repay debt. However, they measure slightly different things.
- DTI (Debt to Income) is the percentage of a borrower's gross monthly income that is used to pay monthly debt payments. It is calculated by dividing total monthly debt payments by gross monthly income (usually the denominator is coming from Adjusted Gross Income or AGI from tax returns).
- Household DSR (Debt Service Ratio) is the percentage of a borrower's disposable monthly income that is used to pay monthly debt payments. Disposable income is gross income minus taxes and other mandatory expenses. Household DSR as defined by the Federal Reserve captures required household debt payments to total disposable income on average across a large sample dataset.
In general, a lower DTI or DSR ratio is better, as it indicates that the borrower has more disposable income available to cover other expenses.
There are a couple of things that jumped out to me when I first looked at the data above:
- While DTI and DSR ratios trend down as income levels go up, the maximums still tend to be quite high for higher income earners when compared to other groups. In other words, there are still plenty of wealthy households that carry significant consumer debt. More on this later as debt can be a tool to generate additional wealth if managed properly.
- Generally speaking, American households have room to pay down debt faster or in larger chunks (particularly looking at the the median DSR ratios hovering around 9 - 17% of total available income) but appear to pass on doing so. This indicates that paying down debt may simply not be a priority for many households.
There are several plausible reasons as to why Americans have this love affair with debt. Here are the big ones that I came up with:
- The high cost of housing: The cost of housing in the United States is among the highest in the world. This is especially true in major cities, where home prices have skyrocketed in recent years. As a result, many households are forced to take out large mortgages in order to start down the path of owning a home.
- The high cost of education: The cost of education in the United States is also among the highest in the world. This is especially true for college tuition, which has been rising steadily for decades. As a result, many students are forced to take out large student loans in order to pay for college.
- The culture of consumerism: Ah yes, we love our strong culture of consumerism. This means that as Americans, we are more likely to spend money on goods and services than they are to save it. As a result, many households accumulate debt in order to finance their spending habits.
- The availability of credit: Generally speaking, the United States has a well-managed and liquid credit market across different asset classes. This is great for a number of reasons but it also means that it is relatively easy for people to get loans, even if they have poor credit. As a result, many people are tempted to take out more debt than they can afford. On top of this, interest rates had hovered at multi-decade lows for the last 12-14 years (basically since the 2008 financial crisis) prior to their rapid increase in 2022.
- Lack of Financial Literacy / Motivation: When you think about it, as Americans, we aren't very well educated on personal finance at any point in our lives. There's still a stigma associated with talking about money for many folks and there's never a financial literacy course that is officially taught in K-12 or even college-level curriculums. As a result, not too many people necessarily understand what they're getting themselves into when carrying a revolving debt footprint.
Of these five contributing factors, I would argue that only the first is a decent reason as to carrying a high debt load. To generalize further, borrowing money to acquire an asset that will appreciate in value in the future is not necessarily a bad thing. Similarly, leveraging up against an asset to generate additional wealth is a tried and tested tool used by the wealthy. Real estate has historically ticked these boxes and is the largest source of wealth generation for many Americans. It can be done with other asset classes as well, but that's another blog post altogether for another time. While I think we have collectively obsessed a bit too much with owning a single family homes in this country, there's a fair argument that can be made there.
The other comment I'll make re: the above has to do with taking on student loan debt to acquire higher education. To be blunt, I think this is WAY overrated in my opinion. Wages in this country have not come close to keeping pace with inflation and cost of living metrics over the last several decades. So unless you have high income potential from your degree, it's not exactly a great idea to take on huge amounts of debt to finance your education. Incentives are out of whack for most of the players in the industry, so you'll certainly never hear banks, universities, politicians, or even high school / college counselors advocate for not attending college. The reality is if you plan on financing your higher education, make sure the following end up being true:
- You attend a great school, ideally like a top 50 school, but definitely in the top 100 list. Sounds harsh, but there are plenty of great state schools that make this cut. The point is to not attend some rando private school that is barely hanging on to its credentialing and is mired in a bunch of law suits (believe me, it's insane the number of people that continue to enroll in these institutions).
- You have a passion for pursuing a career that has a strong track record of paying well so you're in a position to actually pay back your debt obligations. The usual suspects: Engineering, Healthcare, Law, Business and ancillary careers in these fields.
If the above doesn't jive for you, I would strongly consider alternatives like vocational schools, apprenticeships, community colleges, or pursuing business ownership. I've met plenty of successful people that took these paths and do not have a college degree (or they pursued higher education much later in life when they had better financial stability).
Open Banking: The Future of Consumer Finance
So given the primer on the state of debt as it stands today, I find it interesting to consider the possibilities of what's to come in the future with advances in consumer finance tech. Open banking is a broad term used to capture the idea that technology has finally started to turn the corner within the US banking system such that it's much easier to aggregate and share authorized financial data. There are obviously lots of implications that come with this, some of which we have already started to see. Consider the following:
- It's now table stakes to be able to link financial accounts across different sources and aggregate this data for better financial visibility. This capability has actually been around for a while, but what started as primitive screen scraping and a relatively shady, insecure practice is finally seeing the light of day with secure OAuth and true API based connectivity within the ecosystem.
- The US is finally catching up with the rest of the world when it comes to digital payments and settlement technology. The Federal Reserve is about to release the FedNow protocol in July 2023 (check it out here: https://explore.fednow.org/). The FedNow Service is a new instant payment infrastructure developed by the Federal Reserve that allows financial institutions of every size across the U.S. to provide safe and efficient instant payment services. Bottom line for consumers - people can send and receive instant payments in real time, around the clock, every day of the year. That's a pretty big step up from ACH.
- With the advent of instant sharing and access to financial data, there are creative opportunities to underwrite and provide access to credit to individuals and businesses that have traditionally been underrepresented. In particular, the availability of reliable historical cash-flow data is a game changer when it comes to unsecured lending. As the saying goes, "cash is king!".
Push and Pull: Access to Credit & Rising Debt Levels
There's a natural push and pull effect with the democratization of financial data to an extent. On the one hand, availability of credit has undoubtedly increased and there are a slew of providers that are leveraging more sophisticated fintech models to provide credit to a larger swathe of consumers. On the other hand, total outstanding consumer debt is increasing as a result; and these same consumer loan issuers are exposed to larger degrees of risk for the loans they themselves have been more "creatively" underwriting. I am a firm believer that these two occurrences are very closely linked.
It's an interesting phenomenon that I think speaks to the culture of consumerism that I mentioned earlier. In other words, the first instincts of many of these new age fintechs has been to lean in the direction of leveraging open banking technologies to supply additional credit to the market. Think of advent of BNPL (i.e. Buy Now, Pay Later) providers that have exploded on e-commerce channels. At its core, the large availability and proliferation of credit has been fueled by rock bottom interest rates and the surrounding monetary policies of the last decade and half. But even above and beyond interest rates and monetary policy, I think it's an interesting observation that the psychology of many of these entrepreneurs and investors has been wired to promote the availability of credit as the sexy, desirable financial offering that can disrupt at scale. Never mind the fact that BNPL inexplicably encourages consumer behavior that is fraught with risk....namely buying sh!t that would otherwise be unaffordable. Not surprisingly, valuations for many of these firms took a beating in 2022 when investors got the memo that interest were indeed heading north and potentially staying at elevated levels for a while.
An Alternative : Accelerated Debt Paydown
There is an alternative offering that would theoretically use the same advances in technology and open banking, but to tackle the opposite side of the consumer finance equation: debt! Just as financial visibility and instant cash flow calculations can be used to offer consumer credit, those same data points can come in very handy to educate and potentially automate debt management for consumers. This has been a far less appealing choice in the past because of said interest rate and monetary policy environment, but I think there's the possibility of that changing real soon given the direction that macro-economic indicators are headed in the future. When debt becomes expensive, suddenly consumers might actually care to pay some of it down. And when faced with that choice, it can be overwhelming to consumers when they realize the have a combination of mortgage loans, credit card balances, personal loans, student loans, auto loans, etc. All of these debt instruments have nuances like variable vs. fixed rates, varying term lengths, revolving lines vs. installment loans and a bunch more. The good news is that the DSR and DTI ratios that we walked through earlier suggest that there is at least a decent portion of American households that have enough disposable income that can be redirected to debt pay-down if they choose to make such payments a priority.
On the creative underwriting front, I think the equivalent product offering to BNPL would be something that sounds more like this: "pay down a chunk of debt now, pay us back later". Think of it as a short-term (i.e. 4-12 month) advance that is disbursed directly to an appropriate creditor as an additional principal payment; the additional principal payment today would result in immediate interest savings for the consumer. The cash flow analysis used to support the advance would allow for its payback to the provider over the course of the next 4-12 months. The process could then be rinsed and repeated for an accelerated payoff of debt. The capital provider in this case could earn a decent yield, the platform provider facilitating the money movement could monetize the offering by charging a percentage of the interest savings generated for the consumer, and the consumer would win by leveraging their own cash flows to more quickly pay off their debt. At its core, this is essentially a better form of debt refinancing that prevents the "resetting of the clock" that often leads to a revolving debt trap for consumers. Aside from this, it also provides the consumer with a front row seat to their own progress.
I'll conclude by stating that I think there's ample room for FinTechs to innovate in helping consumers actually end up in a better financial footing rather simply focus on access to credit and debt proliferation. Given the times, I think we'll start to see more innovation on this front.
