Recent developments in the credit card market and the financial obligations ratio.

Over the past fifteen years, U.S. households in the aggregate have devoted an increasing share of their after-tax income to the payment of financial obligations. Much of the increase is attributable to a rise in the level of credit card debt, which has raised the share of households' aggregate after-tax income that is devoted to credit card payments. In turn, the rising share of credit card debt in overall financial obligations may stem from several notable changes in the credit card market over this period.

Financial obligations such as credit card debt and housing costs require monthly payments whose level relative to income is, of course, a vital concern to the individual household. A household's choice to take on obligations that increase these payments may represent an accurate assessment by the household of its ability to make payments on its obligations. However, devoting more income to required debt payments and other obligations will make the household more likely to default in the event of job loss or illness.

Likewise, an aggregate measure of payments on household financial obligations relative to income is of interest to economic policy makers because of potential concerns about the vulnerability of the household sector as a whole. In 1980, the Federal Reserve Board began calculating and tracking the ratio of households' aggregate required monthly payments on mortgage and consumer debt to their aggregate after-tax (that is, disposable) income, a measure called the debt service ratio (DSR). To gain a broader picture of households' financial position, the Federal Reserve Board in 2003 introduced a new measure, called the financial obligations ratio (FOR). (1) The new measure added other types of obligations to those of the DSR, namely payments on auto leases and housing expenses for rent, homeowner's insurance, and real estate taxes. As with the DSR, the obligations in the FOR are presented as a share of aggregate, after-tax income.

For a given level of aggregate income, no clear line separates an appropriate level of payments on financial obligations from an excessive one, but the current level of the FOR is elevated relative to historical experience. It stood at 18 1/3 percent in the second quarter of 2005, a level noticeably above its value fifteen years earlier (chart 1). Of the major components of the FOR, the ratio of credit card payments to disposable income rose the most over this period. Mortgage payments also rose significantly as a share of income, but payments on other types of debt obligations fell (chart 2).

This article argues that three important developments in the credit card market over the past fifteen years account for most of the rise in credit card payments relative to income. First, improvements in credit-scoring technology and the advent of risk-based pricing of credit card debt have increased the share of households--particularly lower-income households--with a credit card. Second, in the 1990s, credit card interest rates began to vary with changes in broader market interest rates. In turn, this co-movement led to an especially pronounced decline in credit card interest rates when, beginning in 2001, market rates turned sharply lower; the decline in credit card rates raised the demand for credit card debt. Finally, households have increased their use of credit cards as a convenient means of paying for daily purchases.

The article estimates the quantitative effect of each of these three developments on the revolving consumer (that is, nonmortgage) credit portion of the FOR--the ratio of required minimum payments on revolving consumer credit relative to disposable income. (2) The analysis indicates that these three developments in the credit card market together accounted for most of the rise of the revolving credit FOR and played a strong role in the rise of the total FOR.

In a concluding section, the article considers these findings in relation to the possible economic implications of the rise in the revolving credit FOR. For example, a rise in required credit card payments stemming from a greater use of credit cards to pay for day-to-day purchases may not signal greater financial vulnerability if households are willing and able to pay off these card charges each month. In addition, the rise in payments associated with the increase in credit availability due to credit scoring may be accompanied by some benefits: More widespread access to credit may help more households maintain their consumption during temporary income disruptions and in turn contribute to the stability of the macroeconomy.