Should You Pay Down Student Loan Debt or Save for a House?
As people graduate college, get their first job and start wanting to settle down, it’s common for a person to find themselves having to decide whether they should save for a down payment on a home or to focus on paying off their student loans.
It can be a hard decision to make, so we’ve put together some advice and questions you should ask yourself.
Key Questions to Ask Yourself About Home Ownership
Buying a home is a huge commitment and paying off student debt can be a huge relief financially. Deciding which is the right thing to focus on is difficult. When trying to decide, ask yourself these questions.
Are you ready to own a home?
The most basic question to ask is whether you’re actually ready to own a home. Though many people say that renting is throwing money away, renting rather than owning a home brings a lot of benefits.
One huge benefit of renting is that it is much easier to move. When your lease expires, you have nothing tying you to your current location. You could easily move across the country. If you own a home, you have to deal with selling the home if you want to move.
Another benefit is that you don’t have to handle upkeep on a rented apartment. Your landlord does all that work for you. This can be a significant plus if you aren’t handy. It also means that any unexpected and costly repairs don’t come out of your pocket.
Will you live somewhere affordable?
Another important question to ask is whether homes, where you want to live, are affordable. Also, consider how much homes cost versus the market rate for rent.
A good rule of thumb is to keep your mortgage payment and other housing costs below 30% of your income. If you can’t afford the kind of home you’d like on that percentage of your income, you’re probably better off renting.
Consider the following example:
John borrows $250,000 for a 30-year mortgage and an interest rate of 4.5%. John makes $4,250 per month. His monthly mortgage payment is $1,267, which is below the 30% rule of thumb. However, John also has to consider costs like private mortgage insurance (PMI) and real estate tax. Assuming a PMI rate of 0.5%, that adds $104 to his monthly payment. If John lives in a high-tax area, such as Boston, Massachusetts, real estate taxes could run as high as $10.48 per $1,000 in home value. If John’s home is worth $300,000, he’ll pay $262 per month in taxes.
When all is said and done, John’s monthly payments come to $1,633. That’s 38% of his monthly income. Other bills and needs like groceries will quickly stack up, and it could be hard for John to make ends meet. If he can instead rent a one-bedroom apartment for $1,200, his monthly budget will be much better off.
By contrast, consider Sarah who the same amount per month. She buys a smaller home and takes on just $150,000 in mortgage debt. Her monthly payment is only $760, but her PMI and tax payments will also be smaller.
It’s important to consider all of the costs of homeownership, not just the mortgage payment.
Can you handle the costs of home ownership?
Beyond PMI and taxes, there are even more costs of homeownership to think about.
One of the most obvious ones is upkeep on the home. You’ll have to repaint walls, replace the roof, keep the carpet and floor cleaned, and all of the other small things that keep a house in good condition. This can cost a lot of money. A good rule of thumb is to expect to spend 1% of the home’s value in maintenance each year. If your home is worth $500,000, expect to spend $5,000 each year to keep it in shape.
Beyond the monetary cost, owning a home requires an investment of time. You’ll need to mow the lawn and do other household work. While you can hire other people to do the work, that increases the costs significantly.
Can you manage a mortgage and other bills?
If you want to buy a house while still paying your student loan, consider whether you can handle having both at the same time. You’ll have to make monthly payments on each loan, and missing a payment can have significant consequences.
Make sure you have room in your budget to pay both loans while still covering needs like food and utilities.
Pros and Cons of Buying a Home
|You'll own an asset that adds to your equity||Could be a burden to sell if you decide to move|
|Eliminates need to rent and be limited by a landlord's rules||Unforeseen maintenance and repair costs|
|Financial and personal achievement and milestone||Property taxes and home insurance premiums to worry about|
|Potential for increase in property value||Increase ownership responsibilities (e.g., renovations, homeownership assocation rules,etc.)|
Key Questions to Ask Yourself About Student Loans
What's the interest on your student loans?
Consider what interest rate you’re paying on your student loans and whether the rate is fixed or variable.
If you have student loans with high interest rates, 6%, 7%, or higher, you should probably focus on paying those off as quickly as possible. Letting them sit, accruing interest will result in you spending a lot of money on paying the loans off. Variable rate loans should also be handled because their rates can increase if market rates increase.
What is your debt-to-income ratio?
Relatedly, consider what your debt-to-income (DTI) ratio is. This is the ratio of your total debts to your annual income. The lower this is, the better off you are. Your student loans contribute to a higher DTI ratio.
One reason that your debt-to-income ratio is important is that it affects your ability to make payments on your debts. The more money you have in relation to your debts, the less you have tied up in making minimum payments each month.
Another reason the ratio is important is that it affects your ability to get a loan. Lenders like to see a low debt-to-income ratio from applicants. Applying with a high ratio could lead to denial or a higher interest rate.
Emergency Fund Comes First
Possibly the most important question you can ask yourself if whether you have an emergency fund already. Everyone should have an emergency fund, but it is absolutely essential for homeowners to have one.
An emergency fund is an extra stash of money that you keep separate from your spending money. Keep it in a savings account and don’t use it unless a true emergency, such as a vehicle breakdown or job loss occurs. Having an emergency fund can be the difference between handling an unexpected expense and winding up in debt because of one. If you don’t have one, you should focus on building an emergency fund before considering any other large financial commitments.
Emergency funds are essential for homeowners because of the unexpected costs that go with owning a home. You never know when a water heater could go out or your roof could spring a leak. You’ll need the cash to handle those surprises.
Saving for a Home Down Payment
If you’ve considered the above questions and think you’re in the right position to purchase a home, the first thing to do is to start saving for a down payment.
We recommend using an online savings account to save for a down payment. They pay far better interest rates than other savings accounts do. They also make it somewhat more difficult to access the money, reducing the temptation to spend it.
Set up automatic transfers from your checking account so your down payment balance grows each month without your thinking about it. Keep making student loan payments while you save, and soon you’ll be able to start looking for a home.
Refinancing Student Loans
Another thing to do if you want to buy a home while paying off student debt is to look into refinancing your student loans.
Refinancing your loans means taking out a new loan to pay off your existing ones. This can reduce the interest rate on your debt, saving you money. It also lets you turn multiple loans into one easy to handle the monthly bill.
One strategy that you can use when refinancing is to refinance your existing loans into a new one that has a lower monthly payment. You can reduce the monthly payment by extending the loan’s term or by reducing the interest rate. Either way, this frees up some of your cash each month, letting you put it towards saving for a down payment or paying your mortgage.
Lenders will appreciate you having a lower monthly payment because it means you’ll have an easier time when it comes to handling payments on a new loan. That can make it more likely that your mortgage application will be approved.
Buying a home is a huge commitment but many people see it as the next step on their path to financial success. While it’s possible to buy a home while continuing to pay off student loans, it can be difficult.
Take the time to consider your financial situation and whether you can handle both debts at the same time. Also, make sure that you have an emergency fund so that you can handle any unexpected expenses that are sure to appear.