Spotlight on Financial Services

How to Spend More Than Your After-Tax Income

At various stages in their lives, consumers spend more than their after-tax income. If they did not do so, there would be no American Financial Services Association and no Spotlight on Finance. There are two ways in which consumers spend more than their after-tax incomes; (1) they borrow, and (2) they tap into their assets, or dissave. This article takes a brief look at two segments of the population who have recently been spending more than their after-tax incomes.

Spending and use of credit by young households

Since young households seldom have substantial assets that can be used to generate funds, they are likely to turn to consumer and mortgage credit to finance their needs. Because borrowing follows households' expenditures, an analysis of changes in their borrowing patterns should begin with an understanding of changes in the expenditures of young households, specifically those headed by persons under age 25. At the outset, it is worth noting that, on average, these consumers spend more than their after-tax income. Whereas their average after-tax income was $17,431 in 1999, their average expenditures were $21,725. The gap was largely financed by their use of consumer credit. (Annual expenditures are adjusted for inflation.)

What types of expenditures accounted for their need for credit? After adjusting for inflation, young households spent 3 percent more in 1999 than in 1990. However, as the table below shows, changes in the type of spending were far from uniform. Changes in expenditure patterns reflect changes in life style. A significant shift was the expenditures on transportation, with the 13.1 percent growth reflecting the boom in car sales during the period. These young adults were not ringing up charges on their credit cards by eating out. Instead, they increased their expenditures on food at home by 11.6 percent, while decreasing outlays at fine restaurants by 18.9 percent. Also, compared with households ten years ago, today's youthful households drink less, smoke less and read less.

Average Spending by Households Under Age 25 (Dollar amounts adjusted for inflation)
	1999-$	1990-$	% Change
Before-tax income	18,276	17,959	1.8
Personal taxes	845	1,075	-21.4
After-tax income	17,431	16,884	1.0
Total spending	21,725	21,064	3.1
Housing	6,585	6,176	6.6
Transportation	5,037	4,454	13.1
Food	3,354	3,519	-4.7
Food at home	1,828	1,638	11.6
Food away from home	1,526	1,881	-18.9
Education	1,277	1,941	-22.7
Apparel and services	1,192	1,318	-9.6
Entertainment	1,149	1,062	8.2
Personal insurance/pensions	1,110	1,239	-10.4

Tapping into existing assets

Why has consumer spending not declined more in these slack economic times? Over the past year (indeed, the past several years) older consumers have been able to raise large amounts of funds from their investment in their homes. The latest Federal Reserve Bulletin shows that in the first quarter of this year, consumers' total personal income reached $8,554.9 billion, of which they paid $1,371.8 billion in taxes, leaving them with $7,183.1 in disposable personal income. (All of these data are at annual rates.) But, during the first quarter, consumers spent $7,247.5 billion, leaving them with a shortfall at an annual rate of $64.4 billion. The accompanying chart shows that consumers spent more than their after-tax income in three of the past five quarters. Moreover, the amount of "negative savings" or "dissavings" increased each quarter. Are we, in the words of a theoretical economist, "going to Hell in a handbag?"

Printer-Friendly Chart

Happily, this is not the case. But, where do consumers get the money to spend when it does not come from their incomes? They must be drawing down their savings in order to spend more than their after-tax income. And, one of the most important sources of savings that consumers have are their homes, whose market values have been rising in recent years.

Homeowners have at least three motives to refinance the mortgages on their homes. First, if mortgage rates have fallen, homeowners can refinance their existing mortgages at lower interest rates. Without increasing the size of their existing mortgages, they can lower their monthly interest costs and have more to spend. Alternatively, if their existing mortgage is modest in relation to the market price of their home, they can refinance with a larger mortgage and have the difference between the old and new mortgage to spend. Finally, they might take out a second mortgage on their home to absorb some of the difference between the market value of their home and the existing first mortgage. The second mortgage provides the extra money to spend. The cash flows generated by these maneuvers are not considered (or taxed) as personal income. But, since they finance personal expenditures, they generate the dissavings reported by the Federal Reserve.

In his excellent article in the Wall Street Journal, Patrick Barta reviews how consumers have used these alternatives and how they have affected the economy. He quotes Sung Won Sohn, chief economist at Wells Fargo & Co.: "The truly important stabilizer of the economy right now is wealth coming from homes." Economy.com (Westchester, PA) has estimated that homeowners refinanced a total of $495 billion of mortgage loans during the first six months of this year. In his most recent testimony before Congress, Alan Greenspan observed that consumers' spending has been "assisted in part by a continued rapid growth in the market value of homes from which a significant amount of equity is being extracted." A critical issue is whether the economic boost from spending from mortgage refinancing peters out before the economy is strong enough to "go it alone" without the dissavings from mortgage refinancing.

With home prices rising and mortgage interest rates falling, lenders are actively encouraging homeowners to refinance and take out some of the gains in the market value of their homes at the same time. The transaction does have its drawbacks. With the larger mortgage, the monthly payments may be higher and the maturity of the mortgage loan more distant.

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