Buying a Home in California as a Student Loan Borrower Could be Dangerous

Buying a house in California right now could work out just fine, or it could be the purchase that wrecks your finances. Based on the sentiment I’ve heard doing hundreds of student loans plans for California residents, I’m worried.

This blog focuses on student loans, but student loans belong to humans. I want to cover whatever five and six-figure student loan borrowers are dealing with in their financial lives. Now more than ever, it’s the temptation to reach and buy a home in expensive markets to “get on with life.” But in California, you can't buy a house because of student loans, which is an unfortunate possibility. Nowhere is this financial challenge more difficult in a state other than California right now. In California, student loans affect mortgage approval.

Here’s a taste of what professionals with high incomes and six figures of student loan debt are saying about California real estate.

“I have kids and I want to live in this school district no matter the price.”

“If I don’t buy right now, my financial advisor says I might never be able to afford a home in California in my lifetime.”

“There’s no supply. All these rich young techies guarantee the market will never fall more than a little bit.”

I believe we could be seeing irrational exuberance in certain markets in California. While speaking with hundreds of California professionals is by no means proof, I’ll explain why buying a home in California as a student loan borrower may not be an easy task. Even buying a house with student loans in deferment might not be the best option. 

This is particularly true if you owe a lot in student loan debt, even though California residents have access to some of the best student loan refinancing options in the country.

California is Far Less Affordable than the Rest of the US

Zillow performed a study looking at the ratios of mortgage payments to income around the country. Nationally, they found that the ratio in the US is 17.1% as of March 2018. However, in LA and SF, that ratio is at 44.9% and 43.9% respectively.

You might say, “well, of course, California has gorgeous weather and is a desirable place to live.” If you compare historical ratios though, the gap has widened between California and the rest of the country. LA used to have a ratio of 34.5% and the national average was 21.1%.

Beautiful California two-bedroom home. Only $2.5 million

The Trump Tax Cuts Could Severely Impact California Real Estate

No one has noticed yet except CPAs and nerds who follow tax law, but 2019 will bring a far more severe tax code for California real estate. State, local, and property taxes cannot be deducted beyond $10,000 for an entire year.

The top tax rate in California is 13.3%. Of course, that rate only hits millionaire earners. Even so, modest incomes still face a tax rate of over 9%. That’s one of the reasons putting money into retirement accounts help so much for student loan forgiveness. Now instead of being able to itemize, many Californians will be forced to use the standard deduction.

Also, your property taxes get lumped into this maximum deduction limit. An upper-middle-class California couple might have been able to deduct the following expenses on their $2,00,000 home and $600,000 income in 2018:

•      $12,000 Property taxes
•      $60,000 California income taxes
•      $80,000 mortgage interest

Total deductions 2018: $152,000

In 2019, the property taxes and income taxes have a $10,000 cap on the deduction. Only the first $1 million of mortgage value is eligible for the mortgage interest deduction. That means that line item gets cut in half.

Here are the deductions for 2019:

•      $10,000 property and income tax deduction
•      $40,000 mortgage interest deduction

Total deductions 2019: $50,000

That means this couple could expect to pay federal income taxes on an additional $100,000 of their $600,000 income. That’s probably going to result in $30,000 to $40,000 less of spending money.

We Have not Had a Recession in a Historically Long Time

Did you know that the US has had a recession every decade going back to 1850? Coincidentally, that’s when California got added as a state.

Since we tend to average a recession approximately every decade, that’s another reason to pile onto the list of concerns for home buying in California. Obviously, recessions are not kind to home prices because incomes typically decline overall during economic contractions.

The Last Recession We Had was Focused on the Financial Sector, Not on Tech

Do you remember what companies were doing fantastically well back in 2007-2009? Most of the big tech upstarts located in the SF bay area. The financial sector imploded and almost brought down the economy.

While the rest of the world was falling apart, tech equity options continued to vest and grow in value, providing young workers in the Bay Area with ample capital to buy homes.

At the same time, interest rates plummeted, which reduced mortgage payments. That’s not intuitive to everybody, so consider that at a 3.5% 30-year mortgage on a $500,000 loan, you’d pay $2,245 a month. At a 6% mortgage rate, you’d pay $2,998 a month.

In other words, during the last recession California benefitted from limited housing supply, surging incomes from the tech boom, and rapidly falling interest rates.

Tech as an Increasing Share of the Economy Has Helped California. It Can Also Work in Reverse

During the last tech crash in 2000, tech as a percent of the total stock market was even higher than it is today. I checked the S&P ETF at Vanguard (VOO) while writing this article and the ratio of tech in the broad US stock market is significantly above long term averages.

Of course, the next step is the S&P is moving some of the big names like Google and Facebook out of the technology sector classification.

What does this all mean? This is my opinion, and I caution that you should talk with your own financial advisor about your investments because I’m not telling you what you should do.

I’m simply stating that when Amazon as a trillion-dollar company has a Price Earnings ratio of over 170 and the long term average of the stock market is about 15, I get worried, especially about tech stocks.

Painting the Scenario of What a Rapid California Real Estate Decline Would Look Like

Pretend in 2019 that parts of the economy start fading and the extremely positive economic sentiment of today reverses. We see interest rates rise overall and mortgage rates tick higher.

The impact of the new tax law finally gets felt, and countless California families have less money to spend on housing as a result.

Later into the recession, we have a shock to the tech sector that results in plummeting interest in Venture Capital, big tech names, and big layoffs in the SF bay area. Snapchat announces big layoffs in LA. Startup equity options suddenly don’t look as valuable.

The combination of rising interest rates, less favorable tax laws, and a recession with a heavy hit to the tech sector rapidly change people’s opinions about becoming home buyers with student loan debt in California, especially first time home buyers. 

The attitudes I’ve heard in student loan consults of “buy at any price” suddenly become “how can I get out of this underwater home while I can.”

Buying a Home in California as a Student Loan Borrower Could Hurt

The above scenario could end up never happening. California real estate prices could indeed continue to rise and never decline significantly.

However, when you have a huge chunk of student debt, I believe you should focus on increasing your assets without exposing your family to undue risk. If you can rent a place to live for a monthly rent less than 0.5% of the purchase price, you’re making a smart decision.

I suggest that student loan borrowers limit themselves to mortgage debt and student loan debt because student loan debt can make buying a home almost impossible in California. If they happen to live in a place where prices of homes are insane, then I suggest you be cool with long term renting rather than owning.

Focus on Having a High Savings Rate and Limit Your Budget as a California Homebuyer

If you can find a place to live for less than 2 times your joint income, then screw what the housing market does. Go buy a place that you’re going to call home for the next 20 years.

That said, I’ve got tons of clients who ask me questions on how to deal with six figure capital gains from selling California real estate. Most of these borrowers are not professional real estate investors. They bought in an exuberant market. If you buy at exuberant prices, that means you could lose lots of money if the market returns to merely above average.

Here’s a list of the top 5 most expensive markets in the country according to CNBC:

1. San Jose, CA
2. San Francisco, CA
3. Anaheim, CA
4. Honolulu, HI
5. San Diego, CA

Notice any trends? Getting a mortgage with student loans in California as a borrower can be tough. When you go out looking for a home in the Golden State, please be careful.

If you want to get a plan for your student debt that incorporates the unique conditions of buying a home in California as a student loan borrower, such as its community property state tax status, we’d love to make a plan for you.

Think I’m onto something about real estate in California or do you think I’m an idiot? I’d love to know either way! Let us know in the comments.