- We’ll discuss how fragile this debt driven economy is from a bottom up perspective.
- You may be surprised by the impact of minor interest rate changes.
- You should reconsider owning cyclical stocks that depend on consumer debt at this point in the economic cycle.

**Introduction**

Things have been good for 9 years now. This is a fact.

Today we’ll discuss how and why things could change because when things are good, people and things become weak and fragile. I’ll connect the dots with student debt, mortgages, and consumption to show how it’s all a mere illusion, or at least a big part of it is.

**Student Debt**

The average student’s debt isn’t that high at $33,000. But what’s interesting is that it’s a burden and it can become bigger if interest rates increase.

If I put an average 4.5% interest rate on $33,000 and a 7-year repayment plan, the monthly payment is $459. Of course, there are some students with $200,000 in debt while some are far less in debt. It’s unwise to use averages, but sometimes they are the best we can do. Nevertheless, the $459 is important for how it weighs the total available debt a person can take, or the debt to income ratio.

**Debt To Income Ratio**

With an average salary of $50,000 after graduation, the debt to income ratio is already at 11% as the average student debt burden is $5,508.

If we add the new car that many graduates buy, the debt burden quickly cumulates. The average new car financing in the U.S. was $30,621 in 2017 which translates to a $571 monthly payment. This adds $6,852 to the yearly debt burden, which means we’re already at 24% for a debt to income ratio.

So, if such a person wants to buy a house at $400,000, they would first need an $80,000 down payment and then the monthly payment would be $1,500, or $18,000 yearly for a $320,000 loan with an average 3.88% interest rate. Add this to the student debt burden and the car payment, and you’ve got a total debt burden of $30,360 which would be 60% of the salary which isn’t allowed.

Let’s say a couple buys a home together, plus student debt, and car loans for two cars, and we come to 42.8% which is just shy of the 43% debt to income ratio limit required to get a mortgage.

**Higher Interest Rates**

Now, what happens when the interest rate on the mortgage goes to 5.88% from 3.88%? The monthly mortgage payment goes to $1,900 for the couple which becomes a significant burden. The couple would also become limited with their future purchases as the possible loan amount they can get will quickly decline.

With the same salary and interest rates at 5.88%, the mortgage our imaginary couple can get goes down from $320,000 to $256,000, so the price they can pay for the house now isn’t $400,000 but $320,000 – thus 20% lower, just from a 2% rate increase.

**Credit Card Debt**

The average American has credit card debt of $6,375 which makes it $16,883 per household and the interest paid yearly is $1,292.

So when you pile all the debt up, you come to a very indicative picture and the fact that household debt relative to disposable income has been surging in the last two years isn’t really a good sign.

As higher interest rates transfer to the consumer, something we haven’t yet seen, the attractiveness of buying on credit will decline, the required income to get a loan will increase, and the payments too will be higher. Just small percentage increases in interest rates have a huge impact on actual consumption and credit payments. Something that inevitably leads to an economic contraction.

**What To Remember**

The key of the above example is that even if you don’t think that an increase in interest rates of 1 or 2 percentage points is significant, it makes an extreme difference in an already stretched environment. This is something to always keep in mind when analyzing investment opportunities that depend on available credit, like car companies and other cyclicals.

In the 1980 recession, the number of cars sold fell by about 50%. In 1990, it was 25%. In 2009, it was almost 50%.

Given that debt for purchasing cars has exploded in the past and is already 37% higher than it was in 2007, I would be very careful when investing in companies that rely on consumer debt no matter how good the situation may look right now.