Why consumers may show more discipline in 2007

After the usual binge of holiday spending, Americans may want to make a resolution of fiscal prudence for the new year: "I will repair my household finances."

This isn't just advice from financial gurus during an era of record household debt. For many families, fiscal discipline is being imposed by the slowdown in the US housing market. Indeed, the number of homes in foreclosure is rising, as many owners fail to meet their mortgage payments.

But there is good news: For most households, this is a relatively benign climate for financial make-overs.

Many borrowers have the opportunity to refinance their debt at low interest rates. Moreover, forecasters generally don't foresee a recession in 2007. A healthy economy could allow consumers to keep spending even as they borrow less and save more.

"I do think that the savings rate will turn firmly positive by [the end of 2007]," says Mark Zandi of Moody's Economy.com, a forecasting firm in West Chester, Pa. But "there is a significant amount of financial stress in 2007."

Some economists, in fact, believe a recession is likely as faltering home prices put a squeeze on family wealth. But the more common forecast is that the housing slump won't cause an outright downturn in the economy.

Members of the National Association for Business Economics, surveyed in November, generally believe the housing market will hit bottom sometime in 2007.

"It looks like the housing decline is in its last phase," says Peter Kretzmer, an economist at Bank of America in New York.

In any scenario, how homeowners grapple with their debts will be a central feature of the 2007 economy.

Consumer spending accounts for about two-thirds of US economic activity. The more people have to scramble to cover their debt payments, the more they may have to curb other spending.

The challenges are greatest, some analysts say, for young households – people who bought homes near the peak of the real estate boom – and for those with lower incomes who stretched to get credit.

For years, amid a nationwide housing boom, people took out bigger and bigger mortgages, and their property values rose just as fast. Rising home values made people feel wealthier, and Mr. Zandi reckons that this "wealth effect" made people spend more than they otherwise would. The nation's personal-saving rate, the difference between Americans' disposable income and their spending, has been negative since the summer of 2005 – the first time since the Great Depression.

Since then, Americans have essentially been dipping into their savings, or sometimes using credit cards, to spend more than they earn.

There's no guarantee that the saving rate will get back into positive territory in 2007. But some economists see signs that households are adjusting their behavior.

In the late summer of 2005, households borrowed an amount equal to 14.6 percent of their disposable income – the highest level in any quarter since World War II, according to Paul Kasriel, an economist at the Northern Trust Corp. in Chicago.

A year later, American borrowing totaled just 8.8 percent of disposable income in the third quarter, lower than any three-month period since the recession of 2001.

People aren't as eager to take out big mortgages when houses have stopped rising in value every month.

Still, households remain highly leveraged. US mortgage debts now total about 46 percent of all US home values. That percentage has more than doubled since the 1950s. "Homeownership is now much more precarious," says Tamara Draut of Demos, an advocacy group in New York worried by America's high consumer debt levels.

Some 45 percent of first-time buyers in 2005 took home loans with no down payment, Ms. Draut says. That means that, should they need to sell the home, they have very little cushion to repay their loan.

In general, home prices rise over time. But for now, prices have been heading down in dozens of cities.

Meanwhile, many homeowners will see their mortgage payments jump sharply in the next year or so, as adjustable-rate mortgages ratchet upward from low introductory rates.

That explains why foreclosures are on the rise: Many owners can't afford the higher mortgage payments, and they can't sell the home for what they paid.

The number of foreclosures was up 43 percent in the third quarter of 2006, compared with the same period the year before, according to Demos.

What can homeowners and other borrowers do to keep their balance sheets in order? Experts say some of the best steps are tried and true: Develop a budget, set aside some savings each month, and don't buy a home costlier than you can really afford.

"There is no substitute for having an emergency savings cushion," says Greg McBride, senior financial analyst at Bankrate.com in North Palm Beach, Fla.

Also, people with adjustable-rate loans, which are often resetting at rates of 7 percent or higher, might want to refinance at lower fixed rates. In addition, Mr. McBride says, "have a plan of attack" to repay high-cost debt such as credit-card bills.

Again, now may be an opportune time. People who get paid every two weeks may have gotten a third paycheck in December, McBride says. They might use that – or a year-end bonus – to pay down debts.

Financial advisers also offer this reminder: Debt can be a good thing if used wisely – such as a path to owning a home.

"Democratization" of credit, with new types of loans available to more people, has generally been a positive force in recent years, Zandi says. "This probably has allowed ... for a more stable economy," he says. But it also leaves many people vulnerable if interest rates rise substantially, or if housing prices falter.