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Debt-to-Income ratio(DTI) is a key figure which is used for many purposes especially from the individual perspective during mortgage approval process. The Wikipedia definition of debt-to-income ratio (often abbreviated DTI) is the percentage of a consumer’s monthly gross income that goes toward paying debts. It helps the lender to figure out whether a certain individual’s income will be able to absorb the new debt by considering their existing debt or in short these ratio helps to find whether individual debt is under control to certain limits compared to their income. That’s the short intro about DTI. In this post we are not going to discuss about individual DTI, instead we are going to see how an individual DTI affects the US Economy and current recovery process.

A recent analysis report published by Texas A&M Real Estate Center about how Household Debt-to-Income ratio is way over the limit can complicate the process of our current recovery. Here is a snapshot of from that interesting read with a detail history how we got to this deep debt levels:

The ratio of household debt to income remained relatively stable from 1965 to 1985, fluctuating in a range around 60 percent (Figure 1).

Then in 1986, a fundamental change occurred. Americans became increasingly comfortable with debt. A closer look at key events from 1986 to 2006 reveals important changes that explain why debt increased significantly and drove massive economic growth (Figure 2).

The Economic Recovery Act of 1981 significantly spurred growth in household debt by lowering personal taxes, making more disposable income available to service debt. The strong growth in debt moderated by 1986 but grew steadily for the next decade. In 1986, the first Baby Boomers turned 40 with their highest earning years ahead of them. They justified taking on more debt by anticipating that their incomes would “grow” into it. This growth in debt fueled a surge in economic activity as Boomers purchased bigger homes, minivans and vacations for their growing families.

In 1996, the Tech Bubble took hold and propelled household debt to a new level. Prior to 1996, borrowing was fueled primarily by current income and expected income growth. After 1996, U.S. households became comfortable with assetdriven borrowing. They expected to fund their retirement years through stock price appreciation rather than traditional savings. Growing stock portfolios gave Americans the confidence to save less and redirect their discretionary income to servicing new debt. The resulting growth in debt fueled strong economic growth. When the Tech Bubble ended in 2001, households turned their lust for collateral to the homes in which they lived. The rallying cry of “My house is my retirement plan” could be heard in the hottest real estate markets across the country. Asset-based borrowing fueled further growth in household debt, which rose to a historically stratospheric level of 130 percent of income.

The widespread use of partially amortizing loans added to the debt level taken on by households. At the peak in 2008, U.S. households were straining under the burden of $13.9 trillion dollars in debt, equivalent to 96.6 percent of GDP. When the real estate bubble burst, the age of deleveraging commenced. Not since the Great Depression have U.S. households exhibited such an adverse attitude toward debt.

Facing Reality

To take the right steps toward economic recovery, the problem of household debt must be confronted realistically. Household debt will not increase and drive economic growth until it has first decreased to its long-run average. The reversion process is especially painful because it must overshoot the average before it can return to average. The overshoot is necessary because household debt has been above the average for so long.Rather than delaying foreclosures and continuing to extend and pretend, the more appropriate action is to accelerate debt extinguishment through foreclosure and bankruptcy. This will free households from excessive debt and give them the flexibility to rearrange their finances and return to a responsible level of borrowing and consumption. Some of these foreclosed homes will become rental property for investors

We must accept that a significant amount of household debt currently outstanding will be extinguished through default. While foreclosure is painful to both borrower and lender, it is a necessary process. Our parents and grandparents have survived difficult times like this. So can this generation. The housing market will begin a real recovery cycle when the foreclosure process nears completion. It has to happen sometime. The sooner the better for the economic future of our country.

Take Away
It will hurt, but American households will have to liquidate their assets and reduce debt if they want the economy to recover. This means selling luxury items including vacation homes, boats and RVs, as well as liquidating investments, declaring bankruptcy or suffering through foreclosure.

As they right worded in the Take Away, we all need to reduce our debt or accumulate debt which can be managed by your Income instead of trying to do by Asset based which may create issue if those asset fall in value. In the same article, they talked about Household Debt-to-Asset ratio and Household Mortgage-to-GDP ration in the same context. You can read the full article by going to recenter.tamu.edu.