The rising tide of student loan debt will create a generation of renters in the United States. Let’s call them Gen R.
We will examine the reasons for this in a moment. But first, a brief positioning statement.
This is not a story about the downsides of renting versus owning a home. They both have their merits. Rather, it is a prediction of a major economic and cultural shift, based on current trends. So let’s start with the trends themselves.
Statistics on Student Loan Debt
When you look at some of the key statistics surrounding student loan debt in the U.S., you can see the writing on the wall. Or at least you will see it, once I’m done making my case. These are the facts:
- In 1996, the average amount of debt accumulated by college graduates with student loans was $12,750. (Source: The Institute for College Access & Success, TICAS)
- In 2008, the average level of student loan debt among graduating seniors had risen to $23,200. (Source: TICAS)
- In 2010, the debt load rose again to an average of $25,250. (Source: TICAS)
- Between 1990 and 2010, the cost of tuition for a public four-year university rose by 116%, after inflation. (Source: Demos.org)
- There is a huge gap between the steeply rising cost of tuition and mostly flat income levels. Between 1990 and 2010, as tuition rose by 116%, median household incomes in the U.S. only rose by 2.1%. (Source: Demos.org)
- In June 2010, outstanding student loan debt overtook credit card debt in total dollars for the first time ever. (Source: Federal Reserve)
- In 2012, the total amount of outstanding student loan debt in the U.S. passed the one-trillion-dollar mark. (Source: FinAid.org) Most of this debt is held by the federal government, by the way — not by private banks.
These numbers are significant on their own. But when you compare the rising cost of college to the mostly stagnant income-growth trends of the last 20 years, you begin to see the true depth of this problem. Tuition hikes are outpacing income growth by leaps and bounds (116% as compared to 2.1%). Naturally, this leads to an increase in borrowing, which is the next chapter of our story.
Increased Reliance on Student Loans
As tuition continues to rise, there is another trend taking place simultaneously. There is a growing reliance on student loans as a primary source of funding. You can probably guess the reasons for this. In a word, the economy. Since 2008, millions of Americans have lost income, equity and borrowing power. So the reliance on borrowing has risen sharply, and with it the level of student loan debt. This is reflected in the chart below.
The chart above (by Demos) shows how the total amount of student loan debt in the U.S. has spiked in recent years. Interestingly, the spike actually begins a few years before the economic collapse of 2008. If you overlaid another chart on top of this one to show how income levels have risen during the same period, you would see a plateau (income) dwarfed by the Mount Everest of student debt. Sooner or later, something has to give.
The cost of college tuition is rising faster than inflation and income. Students are graduating with more debt than their predecessors, but their post-graduation earning power has not risen at the same pace. They are walking out of college with a piece of paper and a mountain of debt. In many cases, they carry the load for decades after graduation.
Declining State Support for Higher Education
In addition to the rising cost of college, we have a downward trend in the amount of state support for education. Between 1990 and 2010, the amount of state funding per public student dropped by 26.1% (source: Demos.org).
The chart above shows declining support for higher education between 1990 and 2011. This is partly why colleges and universities have been raising their tuition costs. And we’re not talking about minor price hikes here. Over the last 20 years or so, the cost of tuition at public four-year universities has more than doubled, rising by 116%. This means students and their parents must spend more, and that spending often comes in the form of student loans.
Defaults and Delinquencies are Rising
As the level of debt among college students rises, so too does the number of defaults and delinquencies. A delinquency occurs when the graduate / borrower misses one or more loan payments. Default occurs when there is a prolonged delinquency. According to the Oklahoma College Assistance Program (OCAP): “[Default] usually happens when payment is at least 270 days late. Default can also occur for failure to submit on-time requests for a deferment or cancellation.”
In March 2011, the Institute for Higher Education Policy (IHEP) published a report entitled Delinquency, The Untold Story of Student Loan Borrowing. It was the result of a five-year study that looked at “more than 8.7 million borrowers with nearly 27.5 million loans who entered repayment between October 1, 2004 and September 30, 2009.” Among other findings, the authors determined that 41% of borrowers faced the negative consequences of delinquency or default.
Usually, it’s the default rate in particular that grabs headlines. But the less-serious delinquencies can also wreck a person’s credit. This study found that for for every student who defaults (by missing several payments) there are at least two others who were delinquent but somehow avoided default.
A March 2012 report released by the Federal Reserve Bank of New York showed that 27% of student loan borrowers are behind in their payments. The bottom line is that both of these things, delinquency and default, can do serious harm to a person’s credit score.
How Debt Can Derail a Mortgage Loan
Debt can hurt you in several ways when trying to obtain a mortgage loan. It doesn’t matter if the debt comes from student loans, credit cards or auto financing. As far as mortgage lenders are concerned, it’s all debt. And too much of it can tip the scales against you.
1. Debt-to-Income Ratio (DTI)
In the wake of the housing crisis, mortgage lenders are paying a more attention to debt-to-income (DTI) ratios. As the name suggests, this ratio compares the amount of money a person earns, and the amount they spend each month to cover their debts. There are two types of DTI ratios. The front-end ratio only includes housing costs, which would be the future mortgage payment in this case. The back-end ratio combines housing debt will all other recurring debts. Mortgage lenders are most concerned with the back-end debt ratio, understandably. The image below shows how to calculate back-end DTI ratio with a student loan in the mix.
DTI requirements vary from one lender to the next. They may become more standardized in the near future with the finalization of the qualified residential mortgage (QRM), a set of mortgage requirements born from the Dodd-Frank Act. Currently, most mortgage lenders prefer to see a back-end DTI ratio of 36% or lower. This is one area where student loan debt can become an issue for would-be borrowers. It can tip the scales too far in the wrong direction.
2. Reduced Ability to Save Money
Most home buyers use mortgages to cover the cost of buying a home. But the mortgage doesn’t cover anything. With the exception of VA and USDA loans, all mortgages require a down payment of some kind. The size of the down payment can vary from 3.5% on FHA loans to 5% or more for conventional loans. There are closing costs to consider as well, and these can add up to several thousand dollars.
Student loan debt decreases a person’s ability to save money. Many graduates find themselves in a situation where they simply have too many debt-related expenses to save for a down payment and closing costs. Credit card debt also tends to pile up during the collegiate and post-collegiate years. And then there’s that car payment to consider. It’s hard to put money aside for a home purchase when you’re paying hundreds of dollars each month just to cover your debts.
3. Missing Payments / Default
When it comes to credit scores, student loan debt can be a blessing and a curse. Making regular payments on credit cards and installment loans can help to establish a pattern of responsible credit usage. This can lead to a good credit score over time. On the other hand, those delinquencies and defaults we discussed earlier can ruin a person’s credit score. Consider the widely used FICO score. This scoring model puts more emphasis on payment history than any other factor.
A single late payment can lower a person’s credit score by 60 points or more, and it can stay on the person’s credit reports for up to seven years.
It’s More Than a Blip on the Radar
Last week, the National Association of Realtors held its midyear legislative meetings in Washington, D.C. One of the panel discussions was entitled “Shifting Demographics and Housing Choice: A Whole New World?” A new world indeed. During that discussion, NAR economist Selma Hepp rightfully stated: “Echo boomers [people who are currently 17 – 31 years old] … are struggling in the current economic crisis. Consequently, demand for rental housing is likely to climb in the near term.”
While her premise is sound, I think Hepp is underestimating the true significance of this shift. I predict we will see a major trend away from homeownership and toward renting, among the so-called echo boomers. It’s a trend that will play out over a period of decades, not years.
Homeownership is the American Dream (and Other Silly Ideas)
“Homeownership is the American dream.” It’s a marketing slogan that dates back several decades. In the last 10 – 15 years, this idea has been drilled into our minds from all corners of the housing industry.
It has become the standard model for success in America. Go to college. Get a high-paying job. Buy a house. And like the automatons from George Orwell’s 1984, we march dutifully to the drumbeat. Some of us, anyway.
But when did homeownership become the American dream? And whose dream is it, really? Historian James Truslow Adams coined the phrase “American Dream” in his 1931 book, The Epic of America. But it wasn’t originally aligned with homeownership. Adams defined it as “a better, richer, and happier life for all our citizens of every rank.” He even went so far as to say the American dream “has always meant more than the accumulation of material goods.”
Somewhere between then and now, homeownership rose to a position of prominence (dominance?) within the American dream. Over the years, this trend was advanced by politicians on both sides of the aisle. But few pushed the idea as hard as Bill Clinton and George W. Bush. Clinton established National Homeownership Day in 1995. Bush once said that every American should be able to “open up their door where they live and say, ‘welcome to my house, welcome to my piece of property.'”
Of course, politicians are often just a mouthpiece for the lobby groups that support them. Such is the case here. Consider, for example, the millions of dollars spent by the National Association of Realtors political action committee (PAC).
The National Association of Home Builders (NAHB) is also one of the largest PACs in the United States. According to OpenSecrets.org, the NAHB’s PAC spent about $3.6 million during the 2008 election cycle alone. When you spend that kind of money, you expect a certain level of support. It’s no wonder why politicians have been pumping us up about homeownership over the years.
In closing, I would propose a different type of American dream, one that is closer to the original. I would define this dream as health, happiness and personal freedom. Housing should support these goals. It should not take away from them. If you wake up one day and realize you are stressed, depressed and downright broke because of the house you own … are you really living the dream?