Consumers have a debt problem: Not enough of the right kind

The Federal Reserve’s next interest-rate decision could be a fateful one for many consumers and in turn for debates about the health of the American spender. Consumers have increasingly been turning to one of the more expensive forms of borrowing—credit cards—in part because other kinds of credit and sources of cash have been harder to come by. Cutting rates could unlock other avenues for borrowing and give consumers a crucial relief valve.

The value of adding more debt might seem odd coming when headline numbers have supercharged worries about the recent rise in delinquency rates. Consumer debt hit $17 trillion for the first time last year, according to the Federal Reserve Bank of New York’s Quarterly Report on Household Debt and Credit.

But behind that headline trend there is a lot to consider. For one, consumer-debt trends adjusted for inflation look different. On that basis, total household debt—including mortgages—has grown just 3% since the last quarter of 2019, according to Fed figures adjusted for inflation by WalletHub, which provides tools and information for personal finance. Inflation-adjusted debt has touched the highest levels since 2009 in recent quarters, but it is still over a trillion shy of the 2008 peak.

Critical, too, is the question of what kind of credit people are using. The type of credit that has been leaned on most heavily of late by consumers is also the most expensive: credit-card loans. As of the second quarter, card balances had grown 11% from a year earlier, versus just a 4% increase in total household debt overall, according to the New York Fed’s report.

A big reason for that might be because other kinds of credit aren’t nearly as accessible right now, for reasons that include rising funding costs—another upshot of higher interest rates—faced by would-be lenders.

Take personal loans. In the past, consumers have used personal loans to refinance their revolving card balances into often cheaper monthly debts. Banks’ average two-year personal-loan rates as of May were just under 12%, well below cards’ rates of around 22%, according to Federal Reserve data.

But unlike deposit-funded banks, many personal-loan lenders are fintech firms that get their funding from the market. So they have fully borne the higher cost of funding as interest rates rise. These kinds of lenders have also faced market skepticism about their lending practices, incentivizing them to focus on the most creditworthy borrowers.

As the Fed raised rates, the growth of personal lending slowed sharply. The total balance of unsecured personal loans in the second quarter grew just $14 billion from a year prior, far slower than the $46 billion year-over-year surge in the second quarter of 2022, according to TransUnion.

That might turn around when rates start to decline. Funding costs for many online lenders can be closely tied to market rates and so will likely fall as well. And lower average monthly payments on loans can enable more approvals. Buy-now-pay-later provider Affirm, for example, recently told analysts that lower interest rates will likely help spur a jump in volume as it approves more users.

Consumers have other options to raise cash for general use—but they too are very expensive, or otherwise hard to access right now. Thanks to rising home prices, Americans have significant wealth available to them in the form of home equity. Mortgage holders had a record $11.5 trillion in tappable equity as of June, according to home-price and mortgage data from Intercontinental Exchange.

Along with that, balances on home-equity lines of credit have risen 20% since the end of 2021, according to a recent analysis by researchers at the Federal Reserve Bank of New York. The average rate of a Heloc loan is around 9% right now, according to Bankrate, which is less than half of average card rates.

But the pool of people who can get so-called Helocs might be limited. Since 2010, in the aftermath of the global financial crisis, originations have been “overwhelmingly skewed" toward borrowers with very high credit scores, the New York Fed researchers wrote. So a borrower in trouble, or who didn’t have sterling credit in the first place, might not have this relief valve available to them.

It can be easier to take cash out by refinancing a mortgage. However, many borrowers have mortgages at far below today’s prevailing rates. So it is effectively very expensive to swap out their current home loan for a more expensive one. Falling mortgage rates could enable many more homeowners to unlock money via a so-called cash-out refi.

“People who have wanted to get at the really high levels of equity in their homes by doing a cash-out refi may find it more appealing to do so," says Michele Raneri, vice president and head of U.S. research and consulting at TransUnion.

Some consumers right now might be struggling more to keep up with their bills, with higher credit-card bills straining their budgets and maybe even forcing tough choices about skipping payments on other debts, such as auto loans.

Certainly economic factors such as a softening labor market are playing a role. But borrowers also haven’t had the same options they usually do to manage through periods of strain. The Fed’s anticipated rate cuts could be a boon to consumers and lenders.

Write to Telis Demos at Telis.Demos@wsj.com