Prisoners of the Subprime American Dream, Cont'd

When the Federal Reserve raises interest rates, the gap between poorer debtor and richer creditor classes, so far hidden under a pile of cheap credit, will widen and become painfully visible:

By several measures, Americans are more indebted than ever. Through the first quarter, they owed nearly $9 trillion in home mortgages, car loans, credit card debt, home equity loans and other forms of personal borrowing —- accumulating nearly 40 percent of this total in just four years, according to published Federal Reserve data. But most of the debt is at fixed interest rates. Thus it will be unaffected initially as the central bank begins its much expected quarter-point increases in the so-called federal funds rate, now at a 46-year low of 1 percent. The federal funds rate, in turn, influences the interest rate cost of most household and commercial debt.

Only one-fifth of the $9 trillion in total household debt, or $1.8 trillion, is borrowed at variable rates. Variable rates . . . often track what the Fed does, which means they are likely to rise one-quarter of a percentage point over the next few weeks. The immediate cost for the nation's households as a result of this process could be as much as $4.5 billion. . . .

The $4.5 billion is roughly 10 percent of the cost of the rise in oil prices so far this year. That is not a big number yet, but each quarter-point increase would be another step closer to matching the oil shock, which brought gasoline prices above $2 a gallon in many parts of the country.

While the oil shock quickly raised the gasoline and heating oil bills of nearly every household, the burden of higher interest payments falls most heavily in the early stages on lower- and middle-income families. They are the biggest users of variable rate debt, particularly on credit cards, various studies show.

Upper income families, on the other hand -- that is, families with more than $80,000 in annual income -- are more likely to have fixed rate debt, particularly mortgages, and to owe relatively little on their credit cards. What variable rate debt they do have is usually at lower interest rates than lower income people. Lower income people, as a result, are 10 times more likely than upper income people to be devoting 40 percent or more of their income to debt repayment, the Economic Policy Institute reports. In addition, upper income people are the nation's biggest savers, and a rate increase raises the return on their interest-bearing securities.

"If you are a household with a lot of variable-rate debt and little equity left in your home that you have not already borrowed against, this is going to be a scary time," said Mark Zandi, who is the chief economist at Economy.com. . . .

Another notch up in home prices would give . . . some relief; they could float a 4 to 5 percent home equity loan against the additional value of their home and use the loan to pay down credit card debt. Tens of millions of Americans have used this route to lower the interest cost of credit card debt. With homes appreciating more slowly, there is less collateral left to support home equity loans, and paying the outstanding balances will become more costly. They totaled $375 billion at the end of last year. Home prices are a big potential casualty of rising interest rates. Sales of new and existing homes surged in May, the government reported, as people apparently rushed to become homeowners before mortgage rates went any higher. The average 30-year mortgage is already up a percentage point since early spring.

But for Stephen Black, a homebuilder here, the surge in home sales is a false signal. The customer base is already shrinking for his basic product, a two-story house with four bedrooms and a two-car garage on nearly a quarter-acre, a home currently priced at $215,000.

The buyers were families with $50,000 to $70,000 in annual income. Now they are increasingly bunched at the high end. The low end is pulling back partly because mortgages are more costly . . .

Across town, in a rundown neighborhood, the working poor are just starting to show up in greater numbers at Tabor Community Services, a Lancaster agency that counsels those deeply in debt, said Michael Weaver, president of Tabor.

The "fragile low income," as Mr. Weaver calls them, do not tend to own homes, but those who do buy them through subprime mortgage loans, in many cases with adjustable rates. Apart from housing, nearly every transaction for these consumers involves interest payments in one form or another. Lacking enough income, they rent television sets, furniture and appliances, signing agreements that can adjust upward as interest rates rise.

Like their higher income peers, Mr. Weaver's clients often take loans to buy car, in their case, used cars. But they are loans of shorter duration and higher interest rates than the standard four- or five-year new car loan, now averaging 7.4 percent. They have credit cards, but at rates above 15 percent, which convert into much higher penalties when monthly payments are late.

"These are people who are maxed out on debt," Mr. Weaver said, "and their numbers are growing." (Louis Uchitelle, "Families, Deep in Debt, Facing Pain of Growing Interest Rates," New York Times, June 28, 2004)

Cf. Tamara Draut and Javier Silva, "Borrowing to Make Ends Meet: The Growth of Credit Card Debt in the '90s" (September 8, 2003).