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. There were no legal limits to the percentage of borrower income lenders could claim, so lenders provided so much debt that borrowers operated personal Ponzi schemes (borrowed from Peter to pay Paul) to keep their lives afloat.

And why not? Homeowners worried very little about their debt loads because their house appreciated in value and served as another breadwinner. As long as debt was cheap, borrowers never needed their own income or savings to repay, and some dispensed with the need for either income or savings and simply lived off the steady infusions of new debt.

Like other too-good-to-be-true constructs, it went on until it didn’t. The investors who funded these lenders collectively woke up in August of 2007 and realized they were funding several million Ponzi schemes, so they abruptly cut of the flow of free money in a devastating credit crunch. Lenders rudely and abruptly terminated the flow of borrowed money sustaining the lifestyles of the poor and anonymous. While this was painful for the borrowers, it was even more painful for the investors and lenders who did not get repaid.

In the past such episodes of excess were followed by painful purges; however, this time around, with bankers in control of our government, bankers preserved the debts, and overburdened borrowers hopeless tread water in a sea of debt — 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, low labor participation rates, 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 borrower’s ability to repay a loan, they look at two important financial ratios: front-end debt-to-income ratio (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 lenders must modify loan terms and pray their borrowers survive. For the borrowers, they negotiate the best deal they can and struggle with the consequences. For many borrowers 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 prevent future housing bubbles, and one of the biggest reasons is the 43% cap on the back-end DTI imposed by Dodd-Frank.

This cap will ultimately force lenders to limit other forms of debt — if they ever want to underwrite another mortgage. 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.

Since lenders preserved their borrower’s excessive debt loads, the overall economy recovered slowly, and the housing market remains weak because a large portion of the buyer pool simply doesn’t qualify to obtain a home loan.

By Danielle Douglas-Gabriel May 4

A few years ago, as the country grappled with the meteoric rise of student debt, economists warned that education loans were holding back college graduates from buying homes, putting a damper on the economic recovery. Yet a new look at popular data used to support that claim tells a very different story. … “It got sort of lodged in people’s minds that student debt was dragging down homeownership, but the evidence really doesn’t support that,” Dynarski said. “The dividing line between the haves and have-nots is not student debt, it’s a college education.” Dynarski said the biggest flaw in the New York Fed study was lumping together college-educated people without debt and those who never pursued higher education, and then comparing their homeownership rates to those of debt-ridden grads. The problem, she said, is that researchers only used data from credit reports, which contain no information about education, to draw their conclusions.

She commits the same error in her analysis. She needs to parse the non-graduates into those with student loan debt and those without. A large number of people start school, accumulate student loan debt, but then fail to obtain a degree. They get the worst of both worlds as they have the debt, but they lack the high-paying job that was supposed to justify the debt.

The more recent Fed study combined credit reports with data on college attendance from the National Student Clearinghouse, discovering that the greatest disparity in homeownership rates is more tied to education than student debt. …

First, this should surprise no one. Second, it doesn’t negate the argument that student loan debt is holding back the housing market. Student loan debt remains a significant drag, just not as much of a drag as a low-paying job. Obviously, with first-time homebuyer percentages well below historic norms, no single factor is responsible. High prices, low-paying jobs, and excessive debts all contribute to the problem.

To be sure, college graduates with debt do have a harder time buying their first home than those without. Student loan payments are factored into the debt-to-income ratio that lenders use to determine a would-be buyer’s eligibility for a mortgage. Federal rules that took effect a few years ago restrict lenders from extending mortgages to buyers whose total monthly debt exceeds 43 percent of their monthly gross income. Given that ratio, a college graduate with $30,000 in student debt could easily have a difficult time purchasing a home a few years out of school. … Still, having student debt could make it difficult to save for a downpayment on a house, …, said Ralph McLaughlin, chief economist at Trulia, a real estate website. … “Student debt certainly affects young households,” McLaughlin said, “but in the long run, households with a college degree, even if they have debt, are going to be better off than if they did not have that college degree.” Dynarski makes a compelling case for reexamining the impact of student debt on homeownership, but she only looks at undergraduates. People with medical, law or other graduate degrees have a higher chance of amassing six-figure debt that they may not pay off until their 40s. That kind of outsized debt, without comparable earnings, could hamstring would-be buyers. …

People who fall the furthest behind on their student loan payments often have not graduated and are unable to get a job that pays enough to cover their monthly bill, according to the New York Fed. The borrowers with the highest chance of defaulting have less than $10,000 in student debt.“We want to make sure that any reforms we do of the student loan system are on target, and the key problem is repayment, rather than the amount of debt,” Dynarski said. “Folks with a degree … are able to pay their loans, they are able to buy homes. It’s the people who have low earnings, who are dropping out of community colleges and for-profit colleges who are having problems.”

The conclusions drawn by the authors are dubious. Student loan debt service eats a big hole into the 43% allowable back-end DTI to buy a house. It’s not solely responsible for the low first-time homebuyer rates, but it plays a significant role. With sky-high prices, car loans, credit cards, and low pay, would-be first-time homebuyers face plenty of hurdles.

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