What the U.S. Debt Ceiling Limit Means for Your Finances
By Brian Martucci
Date: January 23, 2023
The U.S. government is in danger of intentionally defaulting on its debt obligations for the first time in its history.
The Biden Administration and the House of Representatives, which is controlled by Republicans and led by Speaker Kevin McCarthy, must agree to raise the country’s legal borrowing limit — known as the debt limit or debt ceiling — by early June 2023. If they don’t, the government won’t be able to fund its operations, and financial markets will absolutely freak out. That, in turn, could have far-reaching (and very bad) consequences for your personal finances.
What Is the Debt Limit?
First, a quick review of what the debt limit is and the situation we find ourselves in today.
The debt ceiling is the maximum amount the United States government can borrow to fund its obligations. It’s currently $31.381 trillion.
The debt limit is set by law. No one can raise it unilaterally, not even the President of the United States. The only way it can increase is through Congressional authorization. That is, Congress has to pass a law saying “We are raising the debt limit from x dollars to y dollars.”
One common misconception about the debt limit is that raising it automatically puts the federal government deeper into debt by authorizing new spending. Were this true, not raising the debt ceiling would be a great way to control the size of the federal government.
In reality, Congress must raise the debt limit so that the government can pay bills it has already agreed to pay: Social Security checks, Medicare reimbursements, veterans’ healthcare, military service members’ salaries, and on and on. Congress choosing not to raise the debt ceiling is akin to a business owner deciding not to pay her employees or a homeowner telling his mortgage servicer to stuff it.
But because this misconception is so prevalent, it’s tempting for politicians to use the debt ceiling as leverage in negotiations over future government spending. That’s what happened in 2011, when House Republicans successfully used the threat of default to get the Obama Administration to agree to spending controls, and what’s happening again in 2023.
In the summer of 2011, the government came within hours of defaulting before White House and Congressional negotiators finally hammered out and passed an agreement to raise the debt ceiling. The mere threat of default spooked financial markets and chilled demand for U.S. government bonds, sending yields higher.
Since a wide range of consumer and business credit products yoke their interest rates to U.S. bond yields, this temporarily increased rates on mortgages, auto loans, personal loans, and more — hitting consumers and business owners right in the wallet.
Why Does the Debt Limit Exist?
Basically, because the U.S. Constitution says so. The Constitution requires Congress to authorize all federal borrowing.
Originally, that meant Congress would approve every single Treasury bond sale. This was practically impossible by the early 20th century, so Congress instituted a limited debt ceiling in 1917 and the modern version in 1939.
Has the U.S. Breached the Debt Limit Before?
Yes, but it was an accident. Back in April 1979, when bondholders still held paper certificates and got paid by check, a technical snafu knocked the Treasury’s check-writing apparatus offline for a few weeks. That forced it to delay $122 million in payments to thousands of holders of short-term government bonds.
Markets didn’t like this one bit. Despite it being clear to all that this was an innocent mistake, short-term bond yields spiked by 0.6% in the immediate aftermath. This jump rippled through the economy, making borrowing more expensive for everyone amid already skyrocketing inflation.
A retrospective analysis in 1989 argued that yields never really recovered their pre-glitch levels, though other economists disagreed and short-term bond yields eventually fell to near zero in the 2010s.
Still: If a ghost in the machine could send markets into a tailspin and potentially affect bond yields for years to come, imagine what an intentional default would do.
When Will We Breach the Debt Limit in 2023?
Technically, we already have. The Treasury exceeded the statutory debt limit on January 19, 2023, according to Treasury Secretary Janet Yellen. But just as a money-losing business can use incoming cash and clever accounting tricks to keep its doors open, the Treasury can deploy what it calls “extraordinary measures” to pay its bills in the short term.
That can’t go on forever, unfortunately. The real point of no return is known as “x-date,” when the U.S. officially defaults on its obligations. The Treasury isn’t 100% sure how long its extraordinary measures will work, but its current best guess is that x-date is June 5, 2023.
So Will We Really Breach the Debt Ceiling in 2023?
Unless Elon Musk, Bill Gates, Warren Buffett, and a bunch of other billionaires make a pact to liquidate and donate their assets to the Treasury, x-date will happen in 2023.
If Congress allows it, that is. If the House and Senate come together to raise the debt limit, the U.S. will be able to pay its bills and the threat of default will disappear (for now).
It’s far from clear that this will happen. I’m not a political handicapper, but my take is that the U.S. is closer to default now than at any point in the past, including in 2011.
The problem is that neither side yet seems willing to compromise. House Republicans have ruled out a no-strings-attached “clean” increase that’s not paired with government spending cuts, while the Biden Administration insists it won’t take executive action (which may or may not be legal anyway) to sidestep the limit. Both sides are gearing up to blame the other if and when the U.S. does default.
So I expect the United States to fall into true default for an extended period after x-date — 3 weeks, if I had to bet. It’ll take stomach-churning stock market gyrations, skyrocketing interest rates, and multiple credit downgrades to finally force an agreement.
By then, the damage will be done.
What Does a Debt Ceiling Breach Mean for Your Finances?
As in 2011, we’ll begin to see the effects of a potential debt default before x-date. If it appears Congress won’t pass a debt limit increase in time, or even if it looks like it’ll come down to the wire, U.S. government bond yields will increase significantly in the weeks leading up to x-date. A downgrade by one or more of the major credit rating agencies would compound the problem.
A true default would be uncharted territory, but it’s safe to say interest rates on government debt would rise further — potentially by hundreds of basis points. Here’s what that could mean for your personal finances.
1. Higher Interest Rates on Credit Card Balances
Credit card interest rates are tied to the prime rate, which is in turn tied to the federal funds rate set by the Federal Reserve. So a spike in U.S. government bond yields doesn’t necessarily produce a corresponding jump in credit card rates, as Federal Reserve rate hikes do.
However, higher government bond yields put pressure on credit markets in other ways, especially when the increase is sudden. That creates stress for financial institutions, including credit card issuers, which raise interest rates to compensate.
The bottom line is that if you carry credit card balances from month to month, a debt ceiling crisis similar to 2011 (or worse) will increase your credit card APRs. That means you’ll pay more interest on those balances if you keep paying them off at the same rate. You know what this feels like because your credit card APRs have already increased significantly since early 2022, when the Federal Reserve began hiking rates.
If you do carry credit card balances, now is the time to double down on paying them off. Just like the federal government is doing ahead of a potential debt ceiling deal, look for nonessential expenses you can pare back or cut out entirely in your own budget. And if you’re not already, consider using a more structured payoff strategy, such as the debt snowball or debt avalanche method.
2. Higher Interest Rates on New Mortgages and Existing ARMs
Mortgage rates are closely correlated with U.S. government bond yields, particularly the 10-year Treasury bond yield. When government bond yields increase, so do mortgage rates, and vice versa. A U.S. credit default that causes a spike in government bond yields would cause a corresponding spike in mortgage rates.
If you locked in a fixed mortgage rate before the current debt ceiling crisis began, you don’t have to worry. Your lender can’t legally renegotiate your loan’s terms. But you won’t be able to refinance at a lower interest rate for a long time.
If you’re in the market for a new home, steel yourself for a more expensive mortgage. You may need to lower your sights and accept a smaller or older home than you’d like, cough up a bigger down payment, or even pause your home search until rates come back down (which could take years).
If you have an adjustable-rate mortgage (ARM), expect your rate to increase (possibly dramatically) when it’s next eligible to do so. Now is the time to refinance into a fixed-rate mortgage, even if it means paying a higher interest rate than you are now. The difference won’t last.
3. Declining Home Equity and Higher Home Equity Borrowing Costs
Mortgage demand tends to fall as mortgage rates increase, especially when the economy is weak. That puts downward pressure on home prices, which are already falling nationwide after rapid (and probably unsustainable) increases during the COVID-19 pandemic.
Expect that trend to continue and accelerate in the run-up and aftermath of a U.S. credit default. This isn’t the end of the world if you own a home and plan to stay in it for a while. It could be good news if you’re planning to buy a home in the next few years but aren’t currently in the market.
But if you’re planning to sell your house in 2023 or 2024, or hope to tap your home’s equity to finance a big home improvement project or consolidate higher-interest debt, you could be in for a rude awakening. You’ll have less home equity to borrow against than you did at the same time in 2022, and your home equity loan or line rates will be much higher.
4. Higher Interest Rates on Other Types of Consumer Debt
Mortgages, credit cards, and home equity loans aren’t the only consumer credit products affected by higher U.S. government bond yields. Auto loans, personal loans and credit lines, even portfolio margin loans — all could and likely will sport higher rates if and when the government defaults on its debts.
You know the drill by now. If you’re in the market for a new or used car, plan to take out an unsecured personal loan to consolidate debt, or expect to apply for any other type of credit at all, prepare for more of your monthly payments to go toward interest — and to pay more interest total over the life of the loan.
5. Lower Yields on Savings Accounts
Wait. If the threat of a U.S. government default means higher interest rates on credit cards, mortgages, auto loans, and all the rest, why shouldn’t it mean higher interest rates on savings accounts?
It’s complicated, but basically it’s because banks want to make money. The more interest they pay on savings accounts, the less cash is left for their shareholders.
In normal times, banks are willing to increase savings yields as prevailing interest rates rise because they can also charge more for mortgages and other loans.
But a U.S. credit default would not be normal times. Higher mortgage rates and general economic weakness would combine to pummel demand for new loans, starving banks of a key revenue stream. As it did at the outset of the Great Financial Crisis and the COVID-19 pandemic, the Federal Reserve would likely cut the federal funds rate, the benchmark for savings account yields.
Those savings yields would likely follow suit. And with worried consumers pulling money out of the stock market to stash in FDIC-insured savings accounts, banks wouldn’t feel the competitive pressure that usually supports higher yields.
Other Risks of a U.S. Government Default
I’ve intentionally focused on interest rates so far because it’s what we know best at Money Crashers, but an intentional default would have farther-reaching consequences.
Some are hard to predict, like the extent of the stock market carnage. Others are theoretical and likely to unfold over longer timespans, like a potential geopolitical reordering as other countries lose faith in the United States’ ability to manage its own affairs.
We can confidently predict some nearer-term consequences though. Most Americans will feel their effects — if not directly, then in the economic weakness they portend:
- Government Spending Will Drop Sharply. Maybe this is a good thing in the long run, but it’ll have real economic consequences in the short term. Less government spending means less money in the economy, one of many factors that could trigger a recession after x-date. And it could be politically disastrous if, say, military service members don’t get paid on time.
- Key Government Benefit Programs Could Temporarily Cease. Absent Congressional action, Medicare and Social Security could temporarily stop paying benefits, affecting tens of millions of Americans who rely on them. Other key government programs, like Veterans Administration healthcare, could also be affected.
- Businesses Will Face Higher Borrowing Costs. Higher interest rates won’t only affect consumers. Businesses will pay more for working capital and longer-term loans as well. Heavily credit-dependent businesses, including many exciting startup companies, could downsize or go out of business entirely.
- The Unemployment Rate Will Rise. The combination of lower government spending, a sharp consumer pullback, and business investment cuts will probably tip the U.S. economy into recession. The unemployment rate will rise as a result. The real questions are how high it’ll go and how long it’ll remain elevated.
Is It Really So Bad If We Breach the Debt Ceiling?
It’s a fair question. The United States government has never intentionally breached its own debt ceiling. Most everyone believes that a debt ceiling breach would be anywhere from bad to outright catastrophic, but most people believing something doesn’t make it so.
So maybe all the doom and gloom is unwarranted.
Maybe. But I don’t think so. According to the Washington Post, Congressional Republicans are actively working on a “Plan B” to direct the Treasury to prioritize essential and/or politically popular government functions like military payrolls and Social Security benefits. This suggests they’re concerned about what would happen in an actual default, despite their insistence that now is the time to finally rein in government spending and threatening default is the way to do it.
The Biden Administration is certainly worried. On its web page explaining the debt limit, the Treasury warns that “[f]ailing to increase the debt limit would have catastrophic economic consequences…that would precipitate another financial crisis and threaten the jobs and savings of everyday Americans — putting the United States right back in a deep economic hole, just as the country is recovering from the recent recession.”
Anyway, this exercise isn’t strictly theoretical. In 1979, we saw what happened in the wake of a teensy-weensy accidental default. In 2011, the U.S. government faced real consequences — an unprecedented credit downgrade, paired with gut-wrenching market volatility — for the same sort of brinkmanship that’s happening today.
So while no one truly knows what would happen in a true default, I’m not sure we want to find out.
If Congress and the Biden Administration can’t get together to raise the debt limit by sometime in June 2023, the United States government will intentionally default for the first time in history.
The fallout will affect every American, one way or another. The risk I’m watching most closely is the risk of much higher interest rates on U.S. government debt in the run-up to and aftermath of default. Higher rates could mean:
- Higher costs for everyone who carries credit card balances
- Higher costs for other types of consumer debt, including auto loans and personal loans for credit card debt consolidation
- Bigger monthly mortgage payments for new homeowners that could put homeownership out of reach for many Americans
- Significant home price declines due to lack of demand for owner-occupied housing, draining billions in existing homeowners’ equity
- Higher business borrowing costs, with widespread layoffs likely as companies curtail spending
Unlike in 2022, when yields on U.S. government bonds increased as the Federal Reserve raised the federal funds rate, savers won’t benefit from higher rates induced by default. In fact, the Federal Reserve would likely slash the federal funds rate after default, dragging down savings account yields closely tied to that benchmark.
So in 2024, we might find ourselves in an unprecedented situation where homebuyers have to drain savings accounts that pay almost nothing to afford double-digit mortgage interest rates. Good times.
Source: Money Crashers
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