Inflation Takes Its Toll as Consumer Loan Delinquencies Rise

While the strong labor market remains the key pillar supporting the finances of resilient US consumers, major nonmortgage consumer loans have seen delinquencies increase as inflation has taken a toll on wallets, and more profoundly on lower-income segments.

The quality of the assets in consumer loan portfolios remains susceptible to potential cracks in consumers’ financial health caused by the prospect of a “higher-for-longer” interest-rate environment, any weakening in the labor market, or lackluster wage growth. However, healthy consumer balance sheets driven by stable leverage, manageable debt-service capacity, and real wage growth bode well for the credit performance of consumer lender portfolios and consumers’ financial well-being.

Banks Positioned to Withstand Worsening Consumer Credit

US banks and nonbank financial institutions are well-positioned to withstand further deterioration of credit performance in certain consumer loan portfolio segments, due to the fairly healthy state of US consumer finances and the tighter credit underwriting of the past several quarters.

The strong labor market is still the key pillar supporting resilient US consumers. Nonetheless, major nonmortgage consumer loan types have seen delinquencies increase as inflation has taken a toll on consumer wallets, while higher interest rates have squeezed disposable incomes.

On the positive side, the fact that wage gains have exceeded the pace of rising prices since the second half of last year should partially help consumers absorb higher debt costs. Furthermore, on aggregate, consumer leverage remains slightly below prepandemic levels, while debt-service capacity is sturdy. That said, consumer loan portfolios are susceptible to potential cracks in consumers’ financial health caused by the prospect of a “higher for longer” interest rate environment, any weakening in the labor market, or lackluster wage growth.

Delinquencies for Nonmortgage Consumer Loans Have Increased but Are Within Normal Ranges

Across various household debt segments, credit is generally performing within cyclical ranges. However, there are some differences in delinquency rates among the various debt types. Delinquencies for residential mortgages have been muted, as most homeowners benefited from the low interest rates on mortgages that originated before the Federal Reserve started tightening rates.

On the other hand, delinquencies for major nonmortgage consumer loan types, including credit cards and auto finance loans, have increased over the past year from unsustainably low levels since the pandemic. Nonetheless, despite the recent uptick in nonmortgage consumer loan delinquencies, they are within the normal range and significantly lower than the peak during the 2008 financial crisis. The upward trend has occurred despite the strong labor market, and it diverts from the historical pattern whereby delinquencies typically move in tandem with rising unemployment.

The higher cost of living and increased monthly loan payments due to higher rates (and borrowed amounts for auto loans) have further stressed consumers and are contributing to rising delinquencies, especially on the riskier end of the credit spectrum. Additionally, consumer savings balances increased significantly during the pandemic, driving more punctual monthly debt payments that resulted in higher credit scores and thereby improved access to credit. This may have masked riskier consumers by falsely signaling stronger credit than before the pandemic. The loosening of credit underwriting for most types of consumer loans in late 2020 through early 2022, as the economy was recovering from the pandemic, also contributed to the observed rise in delinquencies.

So far, consumer lenders have been able to manage the impact building loan-loss reserves have had on their earnings. US banks held approximately one fifth of the $13 trillion of residential mortgage debt on their balance sheets at year-end 2023 and indirectly held a nearly equal amount through mortgage-backed securities. For nonmortgage consumer debt, US banks have higher exposures to credit card debt, as they hold approximately 85% of the $1.3 trillion credit card debt outstanding at year-end 2023 on their balance sheets (which is highly concentrated among the top 10 issuing banks).

In contrast, auto loans have a more diversified and highly fragmented lender base, with NBFIs and credit unions holding approximately two thirds of the $1.6 trillion of auto loans outstanding at year-end 2023 on their balance sheets, with US banks holding the rest. US financial institutions have little direct exposure to student loan debt since the federal government owns or guarantees approximately 90% of the total $1.7 trillion debt.

We expect further softening in the credit performance of nonmortgage consumer loans in 2024, but we anticipate the impact to be manageable for consumer lenders’ bottom-line results.

Healthy Household Balance Sheets Still Support Consumer Finances

While the growth of disposable personal income slowed in the second half of 2023, it surpassed the growth in household debt both in 2023 and on average over the past five years. As a result, consumer leverage (the ratio of household debt to disposable income) has stayed below the prepandemic five-year average, suggesting that on aggregate, consumers have not overextended themselves. This mostly stable leverage may have helped US consumers partially moderate the pressures that higher interest rates and inflation have had on their finances.

Despite rising borrowing costs, the household debt-service ratio (required debt payments on outstanding debt relative to disposable income) has remained close to prepandemic levels. With residential mortgage debt accounting for nearly three fourths of total household debt, lower mortgage payments due to the substantial refinancing activity during the low-rate environment of 2020 to early 2022 is a key contributor to keeping the ratio at that level.

Similarly, trends in the household financial obligation ratio (a broader measure of consumers’ payment obligations, including debt, lease, rent, and insurance) are consistent with the trend registered by the household debt-service ratio. Still, interest rates staying higher for longer and/or a sharp weakening in the labor market would likely jeopardize the resiliency of consumers’ debt service.

Since the middle of 2023, wage gains have exceeded inflation across all income levels, resulting in real income growth for most households. If maintained, this trend would help support consumers’ disposable income and enhance their debt-service capacity, both of which benefit the credit performance of consumer lender portfolios.