Pay Off Debt or Save for a House? — Or Both?

 October 22, 2021
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To pay off debt or save for a house — that is the question, and there’s no one-size-fits-all answer for aspiring homeowners. You might be best served by pursuing these goals one at a time or simultaneously. The answer depends on your finances and whether they can bear the weight of student and home loans.

To determine whether you should pay off debt or save for a house — or pursue both goals:

Should you pay off debt or save for a house?

To decide whether you should pay off student loans or save for a house, the first deciding factor is whether or not you’re financially ready to own a home. Here are a few key questions to ask yourself:

What is your student loan debt like? If your loans are tagged at high interest rates and are eating up your budget, it’s likely wise to get your repayment under control before thinking about homeownership. If your loans have low rates and you’re repaying them strategically over time, however, it could be possible to manage education and home debt simultaneously.
How is your emergency fund looking? If you can manage your student loans but have a lack of savings, your first step should likely be to start building or replenishing your emergency fund (three to six months’ worth of expenses). Once your fund is full, then you might think about amping up your savings for a down payment on a home.
What about your other long-term savings goals? If you’re covered in the short term in regards to your debt payments and savings plan, you might consider how homeownership fits in alongside your other aims, such as saving for retirement. While saving for a down payment, for example, you should still be contributing at least up to the match of your employer-provided 401(k) plan, if your employer offers one.

If your finances are in good enough shape that you’re feeling ready to prioritize saving for a house over paying down debt, consider additional questions specific to the cost of homeownership.

Can you afford a down payment? In 2019, the median down payment for first-time homebuyers was 6% of the home’s value, according to data from the National Association of Realtors.
Can you afford mortgage payments? The median monthly mortgage payment was $975 in 2019, according to the U.S. Census Bureau.
Can you afford property tax payments? The annual tax burden varies significantly by county and state, but expect a four-figure cost.
Do you have the money to pay for maintenance and repairs? You might budget more for home improvement if you’re considering a fixer-upper.
What do property values look like in your area? Use online search tools like Zillow to check out prices for the size of home you’re considering.
What interest rate are you looking at? The Consumer Financial Protection Bureau provides a tool to use to get an estimated interest rate.
Will you be staying put for at least a few years? The break-even point is when you’re better off buying versus renting a home. It could take you a handful of years for your mortgage payments to start going toward the principal of your loan.

If you’re committed to living in a specific area, you have enough money to pay your loans and the costs of buying and maintaining your home, and you’re looking to build your life around a community, homeownership may be a good fit. However, buying needs to be affordable with your student loan debt.

Keep your emergency fund in mind

When deciding whether to pay off debt or save for a house, it’s easy to forget about your short-term savings plan. But building or maintaining your emergency fund is also a prerequisite for homeownership. You wouldn’t want to do all the work of saving up for a down payment only to have to dip into the funds for an unforeseen expense, such as covering routine costs after a job loss or medical emergency.

Most financial experts advise holding three to six months of expenses in your emergency fund. Figure out how much money you’ll need to have socked away in an accessible yet interest-bearing account to get by if your income or expenses suddenly shift. Then start contributing to your emergency fund until it’s full.

Keep in mind that your emergency fund will also pay dividends once you’re a homeowner. It could help you make mortgage payments, at least temporarily, if your cash flow is suddenly thrown out of whack.

If you should focus on debt over saving:
Pick and pursue the student loan repayment goal that will get you closer to ready for home shopping.

Can you afford to buy a house with your student loan debt?

One of the key factors in determining if you should pay off debt or save for a house is whether you’ll be able to qualify for a mortgage based on your current debt payments.

Lenders look at your debt-to-income (DTI) ratio to determine if they will approve you for a mortgage. Your DTI ratio will not only affect whether you’re approved for a mortgage, but it can also influence what type of interest rate you’ll be offered.

There are two types of DTI ratios mortgage lenders consider:

  • The front-end ratio. Also called the housing ratio, this shows what percentage of your income would go toward your housing expenses, including your monthly mortgage payment, real estate taxes, insurance and association dues.
  • The back-end ratio. This shows what portion of your income is needed to cover all of the monthly debt obligations. This includes credit card bills, car loans, child support, student loans and any other debt on your credit report that requires monthly payments. It also includes your mortgage payments and other housing expenses.

To calculate your back-end DTI ratio, take your monthly debt payments plus your housing payments and divide it by your gross monthly income (before taxes and deductions). For example:

  • If you have $500 in student loans, a $100 auto loan and a $1,000 housing payment, your monthly debt payments total $1,600.
  • If your gross income is $4,000 per month, take $1,600 and divide it by $4,000. Your DTI ratio is 40%.

Typically, you want to make sure your DTI ratio is lower than this, and certainly no higher than 43%. This is important because most mortgage lenders have a maximum 43% DTI ratio for you to qualify.

If you have close to this ratio and still really want to buy a home, it’s worth checking with a mortgage lender to find out if you qualify.

“Underwriting guidelines have been changing frequently the past several years on how student loans are handled,” says Jay Dacey, a veteran loan officer based in Minneapolis, Minn. “FHA, Fannie (Mae) and Freddie (Mac) all have different interpretations, and it’s really up to the client’s unique situation to determine how they can impact their ability to get a mortgage.”

Don’t forget the down payment
The typical down payment for first-time homebuyers is just 6%, according to the National Association of Realtors. However, if a down payment isn’t at least 20% of the home’s total value, you’ll need to pay for private mortgage insurance (PMI). The cost of PMI ranges between 0.5% and as much as 5% of the loan amount, according to ValuePenguin.

Should you buy a house if you have student loan debt?

Just because you can afford a home doesn’t necessarily mean you should buy one. There are pros and cons of buying a house if you have student loan debt.

The benefits of buying a house while you still have student loan debt include:

  • Building equity, which is the difference between what your home is worth and what you owe on it.
  • Potentially getting more for your money, depending on where you live, as rent payments may be higher in your area than the mortgage payment on an equivalent home.
  • The possibility of refinancing your home to repay student loan debt, which would involve repaying student loans by tapping into home equity that you have built up due to rising property values or due to making mortgage payments.

You can also start thinking of your home as an investment in your future and a moneymaking tool. Your home could make you money if you get a roommate or rent it out on Airbnb, which could help you pay the mortgage or put more money toward your loans.

Some of the downsides, on the other hand, include:

  • Less money to put toward student loan repayment as you save for a home down payment.
  • Two debt balances (mortgage and student loan) that you’re responsible for repaying.

Ultimately, you’ll have to decide how homeownership fits into your plans. As Dacey says: “The most important factor for someone with student loans is to determine what their plans are in the short-, mid- and long-term.”

How is it possible to save money for a house with student loan debt?

If your finances are in good shape and you’ve decided it makes sense to buy a house, you’ll need to create a plan to save for a house while still being responsible about paying your student loans. You can do this by using one or more common strategies:

Using a graduated savings plan to save for a house

With a graduated savings plan, you can put the majority of your discretionary income toward debt while continuing to save for a house. Each year in the timeline, the proportion starts to reverse, and you pay less on your loans as they decrease and save more toward your down payment for a home of your own.

Let’s say you have $1,000 in discretionary income to put toward student loan repayment and saving for a house each month:

  • The first year, put $900 (90%) toward your loan each month and $100 (10%) toward saving for a house.
  • The second year, put $750 (75%) toward your loan each month and $250 (25%) toward saving for a house.
  • During the third year, start putting $500 (50%) toward your loan each month and $500 (50%) toward saving for a house.
  • Continue until you pay off your debt and can allocate 100% to your down payment.

The idea here is that you are putting more money toward debt at first to reduce the amount of interest being tacked on to your balance owed each day. You’ll also benefit because you won’t have to worry about having lots of student loan debt once you also have a mortgage to worry about.

Meanwhile, you’re creating a growing pool of funds to put toward your down payment when the time comes. The time frame for shifting the amount of money paid toward debt versus savings should be based on the amount of debt you are dealing with and how quickly you want to move into a house.

This scenario works best for borrowers with an average student loan balance. But regardless of your discretionary income or student loan balance, this method can be applied so you can focus on debt first while still making progress on your down payment.

As time goes on, you will have fewer loans and can allot the extra funds to a down payment. In an ideal world, you’d be able to clear your debts before buying a home.

Refinancing student loan debt

If you refinance your student loan debt, your newly refinanced loan may have better terms than your existing loans. You could potentially reduce your loan interest rate and monthly payment through refinancing. This would allow you to manage both a mortgage and student loans since your monthly payment on your student debt would be lower.

Lowering your monthly payment through refinancing could also improve your DTI ratio so you could get approved for a loan when you might otherwise have been unable to do so.

If refinancing your student loans makes your repayment more affordable so you can buy a home faster, you’ll have more flexibility to buy when you’ve decided you’re ready to own a home.