What Is Peak Debt?
Peak debt is the point at which a debtor's monthly interest payments consume so much income that a period of severe austerity or some other drastic action is necessary to avoid bankruptcy.
The term is used to describe out-of-control debt whether it is incurred by a single household, a demographic group, or a nation.
- Peak debt is the point at which interest payments become unsustainable as a percentage of income.
- Spending must be cut drastically in order to pay down the principal on the debt.
- Peak debt is a crisis point that may be reached by an individual, a demographic group, or a nation.
Understanding Peak Debt
The term peak debt has become common in recent years, especially when describing the economies of nations and the fiscal intervention through borrowing that is used to keep them stable. Governments borrow money in order to increase spending and therefore boost their economies. The national debt eventually rises to peak debt.
At this point, spending must be reduced or taxes must be increased so that the government can pay down its interest. It recovers, and the cycle begins again.
Good Debt and Bad Debt
The precise amount of peak debt that is hazardous to the well-being of an entire economy is debatable. According to the International Monetary Fund, the world's economies global average debt-to-GDP edged up to 226%, or 1.5% higher than the previous year. Total global debt reached US$188 trillion by the end of 2018.
In all, 90% of the world's economies have higher debt than prior to the financial crisis in 2008, with a third 30% higher than pre-crisis levels. China was singled out as a major factor behind rising debt levels, although Japan and the U.S. account for half of the total.
A key problem is that paying down debt generally requires a reduction in spending. That reduction has a depressionary effect on the overall economy and leads to a reduction in taxable income for the government to use to pay down debt.
About Household Debt
Household debt, otherwise known as consumer debt, in the U.S. rose to $14.35 trillion as of September 2020. Roughly 25% of that figure was made up of revolving debt, such as credit cards, and 75% being non-revolving, such as mortgages.
Those numbers are so large, they are virtually meaningless. A more relevant number is the consumer leverage ratio (CLR), which measures the amount of debt the average American consumer holds, compared with that person's disposable income. In essence, the CLR reflects how many years it would take to pay off all of your debt if your disposable income was used entirely for that purpose
The CLR is used as one indicator of the health of the U.S. economy, along with many other factors such as the stock market, business inventory levels, and the unemployment rate.
Another popular gauge used to measure consumer debt is the financial obligations ratio (FOR) used by the Federal Reserve. According to the Federal Reserve, when expressed as a percentage, that number reached an aggregate peak of 18.13% just prior to the 2008 financial crisis. Since that time it has been steadily declining. In fact, the gauge hit a 40-year low of 13.74% in the second quarter of 2020, as the effects of the global Covid-19 pandemic had a major impact on consumer spending.
Household Peak Debt
On an individual level, most financial advisors recommend that a person's debt-to-disposal income should equate to no more than 20%. That number might be called peak debt for an individual.
At the end of 2019, the percent for U.S. households stood at 15.12%. That number, which measures mortgage and personal debt, has stayed relatively steady in recent years since hitting its peak during the financial crisis.
Consumer debt is perceived as a far greater negative than mortgage debt. For one thing, the interest rate is almost always substantially higher. For another, it's debt incurred for goods that generally will not increase in value, unlike a home.
Tackling Peak Debt
If your household has reached peak debt, it may be time to consider debt counseling. Once the principal and interest payments on your debt make it difficult or impossible to meet your fixed expenses, you will need a plan to potentially restructure and pay down your debt over time.
The National Foundation for Credit Counseling (NFCC) is a non-profit network of credit counselors that can assist you with getting back on track and gaining control of your financial well-being.