As federal educational aid increased at the turn of the century, more middle-and-lower income families were eager to send their children to college. Without asking many questions, or knowing the questions to ask about whether they were able to foot the $20,000-$40,000 tuition, high school graduates became college students in droves in the last ten years. In the process, they each saddled themselves with tens of thousands of dollars of student loan debt.

Now, those college students are college graduates, and the high amount of student debt coupled with the terrible job market creates a questionable financial future.

Student loans were made without concern for income — much like mortgage lenders who made loans without verifying income. In fact, most enrolling college students had no income and the future income they hoped to receive was the basis for these loans. Now with the undersupplied job market, graduates are strapped with more debt than the salaries they can find will carry — they are underwater, a feeling common to millions of California homeowners with mortgages in excess of their property’s value.

Similar to home loans, college graduates are barred from getting rid of unmanageable debt by cramming the loan balances down to their present worth in the job market. However, students aren’t able to just walk away from their student loans like defaulting mortgage holders since their only way out is under bankruptcy law and those rules now make it nearly impossible to discharge student loan debt.

first tuesday take: The questionable financial future of graduates with excessive student loans will impact the starter-home market for the next decade — the reason for this discussion. Debt-laden college graduates are too financially strapped to embark on first-time homeownership.

Even if an indebted college graduate is interested in becoming a homeowner, lenders will not look favorably on a loan application for a conventional loan if his total debt-to-income (DTI) ratio exceeds 41%-45%. A high DTI ratio for total installment payments leaves him with only the option of FHA financing with a maximum principal, interest, taxes and insurance (PITI)/mortgage insurance premium (MIP) payment of 31% of gross income.

FHA-insured financing will most likely put him in a home with few of his desired amenities. Thus, most recent college graduates will wait to buy a home, by choice or necessity, as they discover they get more for their money by renting.

So rather than become homeowners, many recent college graduates are moving to the cities in search of better pay, more career opportunities and cheaper rent. The appeal of a short commute to work and city nightlife are bringing more twenty-somethings out of the suburbs.

The suburbs are where dreams houses exist, with white picket fences and black granite countertops, so many are deciding to forego purchasing a home until they are more financially stable and ready to settle down. [For more on how people are flocking to the cities for jobs, see the May 2010 first tuesday article, The plight of California to be solved by… cities?]

Just like the housing bubble, student loans were a legislative push toward supplying a college education to the masses (like the GI bill) that created an artificially high demand for post-secondary education. Universities took the influx of revenue to expand curriculum, hire more professors, and construct new academic buildings – without considering that all these improvements were coming out of the pockets of unemployed students (unlike the GI bill) who may never be able to pay off their student loans.

Bachelor’s degree recipients from 2007-2008 graduated with an average of $23,186 in cumulative debt, and every year that number increases by $1,139 (this excludes Parent PLUS loans). If the student decides to continue to a graduate level education, the numbers for both undergraduate and graduate educational debt grow significantly. For students pursuing a master’s degree, the median combined debt upon graduation was $40,208 — for PhD it was $69,754.

Now the effect on real estate transactions: One in seven borrowers who began repaying their college loans between October 1, 2006 and September 30, 2007 defaulted by September 30, 2008. Of the 3.3 million graduates who began repaying their loans between October 2006 and September 2008, the 225,000 who defaulted on their loans have suffered a significant ding on their FICO credit score.

When an indebted college graduate finally lands a well-paying job and becomes financially stable enough to pay on his student loans and purchase a house, his FICO credit score makes him a huge risk in the eyes of a lender.  Thus, he will be unlikely to qualify for a mortgage. [For more information on negative impacts to your credit score, see the June 2010 first tuesday article, The FICO score delusion.]

In the early 2000s, high school students were convinced by good-intentioned guidance counselors that upon graduating from college, a well-paying job would be waiting right outside the door. Four years later, those same high school students, now college graduates, are stepping out of their university auditorium and finding a pathetic array of available job prospects and a very high number of unemployed seasoned employees standing between them and the American dream. Even as job opportunities open up, their pay will be significantly less than these students anticipated when they signed their student loan promissory notes.

Every real estate agent and broker in California is waiting patiently for the next housing boom, expected sometime around 2016. However, in light of the substantial debt so many recent college graduates are shouldering, the housing boom may be more of a pop — potentially hindered or postponed by the debt-laden Generation Y.  [For more information regarding 25-34 year old homebuyers, see the February 2010 first tuesday article, First-time homebuyers and new housing.]

Re: “Placing the Blame as Students Are Buried in Debt” from the New York Times
Re: “Growth in Cumulative Education Debt at College Graduation” from FinAid.org
Re: “Student Loan Default Rates Increase” from U.S. Department of Education
Re: “The next generation of homebuyers has too much college debt” from Bay Area Real Estate Trends