Imprudent student debt debilitates Millennial home shoppers
Excessive debt-service burdens reduces a borrower’s ability to leverage themselves to buy houses at today’s inflated prices.
During the 00s lenders saddled borrowers with excessive loads of debt: housing, car, consumer, student. Debt was cheap and apparently getting cheaper every day, so neither lenders nor borrowers concerned themselves with worries of repayment, particularly with housing debt because the house was supposed to pay that off for the borrower, the borrower never needing their own income or savings to repay. Like all unsustainable constructs, it went on until it collapsed of its own weight in excess. In the past such episodes of excess were followed by painful purges, most painful for bankers who didn’t get repaid; however, this time around, with bankers in control of our government, the debt was not purged, and borrowers are overburdened with debts they can’t realistically hope to repay, all so a greedy bank bondholder or shareholder won’t lose money on a risky bet.
The excess of debt, like a hangover that never goes away, continues to bring pain and suffering to borrowers, and because so many indulged in the excess, even those who didn’t participate feel the pain through diminished economic activity, high unemployment, and weak wage growth — problems that would have corrected themselves if the debt were purged similar to past episodes of bank foolishness. Not all sectors of the economy are equally harmed by the overhang of excessive debt; products and services that require the least debt to fund their income are least impacted, and products and services that require the most debt are the most impacted; thus housing suffers a disproportionately high burden.
Front-end and back-end DTI
When lenders evaluate a borrowers ability to repay a loan, they look at two important financial ratios: front-end DTI and back-end DTI. The front-end DTI is the percentage of income a borrower spends each month only on housing costs: principal, interest, taxes, insurance, and HOAs or other costs. This is typically limited to 31% of total income, but this standard has been both higher and lower at different times. The more important ratio is the back-end DTI, the total amount of debt service of all kinds as a percentage of borrower income. The back-end DTI encompasses the front-end DTI of housing debt, plus it adds all other financial obligations a borrower might have — including student loan debt.
As lenders loaded up borrowers with credit cards, student loans, and car payments, lenders kept adding to the total debt burden as a percentage of borrower income. As long as debt is unlimited — as long as lenders let borrowers go Ponzi — everything works fine. Lenders match the increasing debt service needs of borrowers with new debt — at least until some lenders realize it’s a Ponzi scheme, then lenders abruptly cut off their debt slaves in a cruel credit crunch. By then the sum of all debt service payments consumes such a large portion of a borrowers wage income that bankruptcy becomes the only viable alternative.
The 43% DTI cap
To this day, the competition to enslave borrowers by capturing larger and larger portions of their income goes on unabated, well . . . almost unabated. The new mortgage regulations will prevent future housing bubbles, and they will ultimately force lenders to limit other forms of debt — if they ever want to underwrite another mortgage. The new qualified mortgage regulations cap debt-to-income ratios at 43% of gross income. If lenders burden borrowers with more than 12% of their income going toward other debt service (43% -12% = 31%), then any additional debt subtracts from what’s available to support a borrower’s front-end ratio, which supports a housing payment.
The political pressure to allow debt-to-income ratios above 43% will become intense; however, even if it is relaxed, it will not be effective. The 43% DTI cap simply reflects financial gravity; raising the cap merely permits borrowers to go Ponzi, fly high, fall further, and hit harder when their personal financial bubble pops. If enough people participate, we get a repeat of the housing bust and financial crisis of the 00s.
If we don’t do something about the excessive debt loads, the overall economy will recover slowly, and the long-term health of the housing market will be suspect because a large portion of the buyer pool simply won’t qualify to obtain a home loan.
By Josh Mitchell — December 30, 2013
This year featured yet another political battle over student-loan interest rates. But while Congress resolved that matter, it did nothing about exceptionally high loan burdens, which increasingly are weighing on borrowers and likely putting a drag on the recovery.
Undergraduate borrowers who graduated in 2012 owed, on average, $29,400 in student debt, up a staggering 25% from four years earlier, the nonprofit Institute for College Access & Success said. Americans now owe around $1 trillion in student debt, according to the Federal Reserve Bank of New York.
What should Congress do about excessive student loan debt? The answer most come up with is the wrong one: forgive the debt. The correct answer is to prevent the debt from becoming so large in the first place.
Imagine you are back in school, and you have to choose between (1) taking a job and reducing your playtime expenditures or (2) taking a loan and partying instead of being frugal. Historically, this is the choice faced by most college students, and typically, those who chose hard work and prudence have more successful careers and financial lives than those who choose to be irresponsible and party. It’s a life choice that forms a basis for future life choices that ultimately shapes character. Now look at how this is poisoned by student loan debt forgiveness.
If students know they will obtain debt forgiveness if their debt-service burden is too high, their incentive is to maximize student loan debt and minimize restraint. In fact, once they’ve crossed the threshold of debt forgiveness, any remaining debt is merely free money to spend on whatever they want on the taxpayer’s dime. Would any of you cut a check to a college student to pay them to go on a bender? That’s what you’re doing indirectly if the government starts forgiving student loan debt.
The solution is to limit student loan debt and force students to work to supplement the cost of their education. Not just will this stop student loan debt from getting out of control, it will make them better citizens.
Defaults on those loans are rising. Nearly 12% of all student debt was delinquent by the end of the third quarter, up from 7.6% five years earlier, according to the New York Fed.
The Fed defines delinquent as debt that hasn’t had a payment in at least 90 days. Because that figure includes debt owed by students still enrolled in school and other borrowers who have been allowed to delay payments, the true scope of delinquency is far bigger.
Counting those in deferment is a really lame method of measuring delinquency. The borrowers in question haven’t been asked to repay their loans; of course, they’re not delinquent! Duh!
Research by the New York Fed in 2012 indicated more than 1 in 5 borrowers whose loans had come due were delinquent.
The Education Department’s official gauge—the two-year cohort default rate—shows 10% of borrowers whose loans came due in 2011 were in default within two years. That is up from 6.7% of borrowers five years earlier. The agency defines default as having gone at least 360 days without a payment.
Look at the pains they are going through to disguise the scope of this problem. In order to be counted as delinquent, the borrower must be a full year behind in payments, and a full 20% are that far behind. Incredible!
Officials at the Consumer Financial Protection Bureau have warned that rising student-loan defaults are damaging borrowers’ credit, likely making it harder for former students now starting careers to obtain mortgages, car loans and other types of financing that boost consumer spending and fuel economic growth.
Economists generally agree that student debt isn’t a systemic threat to the U.S. economy. At $1 trillion, student debt outstanding is a fraction of the roughly $10 trillion Americans had accumulated in mortgage debt at the peak of the housing bubble. And while many student borrowers are falling behind, most are still making payments on time.
The only reason this isn’t a threat to the banking system is because the government guarantees all these loans. The debts will be paid; it’s only a matter of who pays them.
But growing student-loan defaults likely are subtly weighing on a U.S. recovery that needs all the momentum it can get to break out of a historically sluggish pace.
The pain experienced by individual borrowers could raise pressure on Congress to ease the burden. The Obama administration has moved to expand an optional program that sets student-debt payments as a percentage of a borrower’s debt and then forgives the balance after a number of years of on-time payments. Some academics have discussed making such a program automatic for all borrowers.
The moral hazard of such a move would be detrimental to the future of this country. Remember Moral hazard is central issue in housing bust; don’t underestimate its corrosive effect.
7170 East COLTER Cir Anaheim Hills, CA 92807
$764,500 …….. Asking Price
$319,000 ………. Purchase Price
7/6/1998 ………. Purchase Date
$445,500 ………. Gross Gain (Loss)
($61,160) ………… Commissions and Costs at 8%
$384,340 ………. Net Gain (Loss)
139.7% ………. Gross Percent Change
120.5% ………. Net Percent Change
5.6% ………… Annual Appreciation
Cost of Home Ownership
$764,500 …….. Asking Price
$152,900 ………… 20% Down Conventional
4.54% …………. Mortgage Interest Rate
30 ……………… Number of Years
$611,600 …….. Mortgage
$156,204 ………. Income Requirement
$3,113 ………… Monthly Mortgage Payment
$663 ………… Property Tax at 1.04%
$0 ………… Mello Roos & Special Taxes
$159 ………… Homeowners Insurance at 0.25%
$0 ………… Private Mortgage Insurance
$100 ………… Homeowners Association Fees
$4,035 ………. Monthly Cash Outlays
($766) ………. Tax Savings
($800) ………. Principal Amortization
$258 ………….. Opportunity Cost of Down Payment
$116 ………….. Maintenance and Replacement Reserves
$2,844 ………. Monthly Cost of Ownership
Cash Acquisition Demands
$9,145 ………… Furnishing and Move-In Costs at 1% + $1,500
$9,145 ………… Closing Costs at 1% + $1,500
$6,116 ………… Interest Points at 1%
$152,900 ………… Down Payment
$177,306 ………. Total Cash Costs
$43,500 ………. Emergency Cash Reserves
$220,806 ………. Total Savings Needed