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In 2015, a Student Loan Hero study of 1,427 adults revealed 41 percent of college-educated Americans with student loans have postponed buying a home because of their debt. The decision of whether to pay off debt or save for a house is a complicated one, but you don’t necessarily have to choose one or the other.
“There is no need to wait to buy until all debt is retired,” said Brian Koss of YourLoanSherpa. “Student loan debt is no different than any other debt.” The key question is whether you have enough for a down-payment and can handle the monthly obligations of both paying back student loans and paying housing costs.
If you’re trying to decide if you should pay off debt or save for a house, read on to find some of the key factors you need to consider — as well as to get some tips on how to save money for a house while still repaying your student loans.
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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 ready to own a home. Here are a few key questions to ask yourself:
- Can you afford a down payment? For most buyers, that’s 6 percent of the home’s value, according to the National Association of Realtors.
- Can you afford mortgage payments, which averaged $758 monthly in 2016, according to Zillow?
- Can you afford property tax payments which average $3,296 per home, according to Attom Data Solutions?
- Do you have the money for costs of maintenance and repairs, which typically cost an average of 1 percent of the home’s value per year?
- What do property values look like in your area? Check out prices using Zillow.com.
- 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 five years? “It takes at least five years to have a reasonable chance of breaking even on a housing purchase. For the first few years, your mortgage payments mostly pay off the interest and not the principal,” Harold Pollack and Helaine Olen wrote in their book, “The Index Card.”
If you’re committed to remaining 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, home ownership may be a good fit. However, buying needs to be affordable with your student loan debt.
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 ratio (DTI) to determine if they will approve you for a mortgage. Your DTI 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, take your monthly debt payments plus your housing payments and divide this 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 total monthly debt payments are $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 percent.
Typically, you want to make sure your DTI ratio is as low as possible, and not higher than 43 percent. This is important because most mortgage lenders have a maximum 43 percent 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,” said Jay Dacey, a senior loan officer with Metropolitan Financial Mortgage Company in Minneapolis, MN. “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.”
You’ll also need to save for a down payment. The typical down payment for 60 percent of first-time homebuyers is just 6 percent, according to the National Association of Realtors. However, if a down payment isn’t at least 20 percent of the home’s total value, you’ll need to pay for private mortgage insurance. This could cost as much as 1 percent of the total loan amount annually, according to Investopedia.
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 the rents 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 money-making 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 large debts (a mortgage and student loan debt) that you’re responsible for repaying.
Ultimately, you’ll have to decide how home ownership fits into your plans. As Dacey said: “The most important factor for someone with student loans is to determine what their plans are in the short-, mid-, and long-term.”
How 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 a graduated savings plan. You can also consider refinancing student loan debt to potentially lower monthly payments. That means you’ll have more money to put towards saving for a home and covering mortgage costs.
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 percent) toward your loan each month and $100 (10 percent) toward saving for a house.
- The second year, put $750 toward your loan each month (75 percent) and $250 (25 percent) to save for a house.
- During the third year, start putting $500 (50 percent) toward your loan each month and $500 (50 percent) to save for a house.
- Continue until you pay off debt and can allocate 100 percent 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’ll 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 so you could get approved for a loan when you might otherwise have been unable to do so.
If refinancing makes your student loans 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.