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If you’ve been out of college for a little while — or a long while — then you might be thinking about home ownership. But if you still have student loans to repay, they may hinder your dream of owning a home.
Should you pay off student loans before buying a house and avoid undertaking new debts? Or is it OK to purchase a home despite lingering student loan debt? As with most financial decisions, the answer to the question of whether to pay off student loans or buy a house is that it depends.
“Each situation is different, so what we look for is the client to guide us on what they feel comfortable doing,” said Jay Dacey, a veteran loan officer in Minneapolis. “If they can afford the payment and we can get them to qualify, that’s a good sign. If we can qualify them for a home and they don’t feel comfortable having that payment, it may make sense to continue living rent-free with parents and/or in a rental they can afford.”
To help you determine the best answer for your situation and goals, let’s take a look at some of the arguments for waiting and some for going ahead with buying a house while you still have student loan debt.
1. Your debt-to-income ratio is too high
When lenders determine whether you qualify for a mortgage, they review how much of your monthly income is devoted to debt repayments, such as payments for student loans, auto loans and credit card debt. The overall result is your debt-to-income ratio (DTI), which further breaks down into the front-end and back-end DTI ratios.
- Front-end ratio: The percentage of your income consumed by housing payments, including a mortgage or rent expenses, and property taxes.
- Back-end ratio: The percentage of your income consumed by all debt burdens, including housing.
To approve potential homeowners for a mortgage, most lenders want them to maintain a front-end ratio no greater than 28% and a back-end ratio no greater than 36%. Some lenders allow back-end ratios as high as 43%, but that doesn’t mean you should take on a mortgage that pushes your DTI to the max.
If your back-end DTI is roughly 36% or higher, it may be best to put off a home purchase until you’ve paid off more of your debt or increased your income. Remember, just because you can qualify for a loan doesn’t mean you should take one out.
Note that one way to lower your DTI is by decreasing your student loan payments. You can do this either by refinancing your debt with a lower monthly payment, which improves the ratio between your monthly obligations and income, or by enrolling in income-based repayment for federal student loans that requires you to make a payment of 10% to 20% of your discretionary income.
However, keep in mind that your total student loan balance can be used by mortgage lenders when calculating the back-end DTI. Alternatively, getting a raise at work or increasing your income through side gigs can help improve your DTI.
2. You don’t have enough for a down payment.
Many financial advisors recommend saving for a down payment of at least 20% of the home’s purchase price. However, homebuyers are not always required to make a down payment of at least 20%. For example, people applying for a Federal Housing Administration loan can make a down payment as low as 3.5% depending on their credit score.
Getting a loan with a low down payment is possible, but if your down payment is less than 20%, then you’ll likely be required to buy private mortgage insurance (PMI), which can add 0.15% to 1.95% of the loan amount to your regular monthly mortgage payment. If you purchase a home for $100,000, for example, then you could pay an extra $12.50 to $162.50 each month in PMI.
Is it a bad idea to buy a home if you don’t have 20% down? The answer depends on a host of factors, including:
- The price differential between the total cost of home ownership, including repairs and maintenance, versus the cost of renting. If owning a home is a substantially better deal in your part of the nation, even after adjusting for additional PMI payments, then it’s a good reason to buy a home with a down payment of less than 20%. The New York Times has a calculator that can help you figure out the price differential by factoring in variables such as interest rates, inflation rates, opportunity costs, the rate of both rent and home price increases, maintenance costs and HOA dues, among other expenses.
- The rising rate of home appreciation. A home can be a good financial investment if long-term appreciation of the real estate market is expected. Home prices have risen steadily in recent years, with the median national home price increasing by 4.8% from May 2018 to May 2019, according to the National Association of Realtors. When prices rise more quickly, it can make more sense to pay PMI for a mortgage because the rapid appreciation in property value can help offset this extra cost.
- Your personal financial situation, including the size of your emergency fund, the stability of your income, amounts of other debt you have and what else you might do with your down payment (i.e., if you’re likely to invest it or spend it).
3. You don’t want to be “house poor”.
Home ownership requires more than simply paying a mortgage each month. In addition, it carries recurring — and unexpected — expenses that renters don’t face.
There are regular maintenance costs, of course, but also repair expenses for sudden problems. For instance, the roof starts leaking, the furnace breaks, the air-conditioner needs to be replaced, the gutters need cleaning, the deck needs to be refinished or the hardwood needs another coat of polyurethane. Feeling exhausted, yet? Your bank account will be.
Make sure that you have enough room in your budget to absorb these potential additional costs, not solely the cost of mortgage payments. The best way to meet this demand is by purchasing a house that costs less than the price at which you’re qualified to buy. For instance, if you keep your back-end DTI to 25% or 30% instead of the lender-recommended 36%, then you can put the savings in a repair and maintenance fund.
4. You’re not sure where you want to be in 10 years.
Renting gives you the flexibility to change careers and move to new cities on a whim. Home ownership drastically limits that kind of freedom.
“If moving in the very near future is highly likely, the transaction costs of buying and selling would offset any potential short-term gains,” said Dacey. “If, however, the client anticipated staying in the location for several years or more, it would likely be to their benefit financially to purchase a home.”
Sure, you can always sell your house, but that can pose plenty of risks, hassles and transaction fees. You could also rent out your house, but you may not want the experience of being a landlord.
If your job is unstable, you’re contemplating a major career or lifestyle change, or you’re not sure where you see yourself in the next few years, then it’s best to wait before committing to owning a home.
5. There’s nothing wrong with renting for a while.
People may tell you that you’re pouring money down the drain when you rent, but there’s no need to rush into home ownership.
If your finances are out of shape or you’re not sure of your long-term plans, then it’s okay — even advisable — to rent and wait until you have more security and clarity before committing to a purchase as big as buying a home. In the meantime, you can work on paying down your education debt.
First, you have to want to buy a home. And the factors in your personal life — your family, your relationships and your commitment to a specific location — must point toward home ownership. In this sense, the only doubt in your mind should be financial, not emotional.
Then, you should consider an array of factors. The more of these criteria you meet, the better. However, if you don’t meet one or two, it isn’t a deal-breaker. Think of the following reasons as a guide, not a mandate.
1. Your DTI looks good.
If your front-end DTI is significantly less than 28%, that’s a good sign that you might be ready to commit to a mortgage while still being able to pay back your student loans responsibly.
2. You’ve saved up a sizeable down payment.
If you’ve been able to pay down your loans and also save enough for a 20% or higher down payment, then that’s another sign that you could be ready to take out a mortgage.
3. You make enough money to cover the costs that accompany home ownership.
See “house poor” above. Buying a home can make sense, as long as you are able to handle the monthly debt obligation and other associated costs of home ownership.
4. You could get more for your money.
Aside from the prospect of building equity — which is undoubtedly a good factor to consider — you could also get more for your money by buying instead of renting. “In many markets, the cost of renting is higher than owning,” Dacey said.
Depending on the market in your area, you might be able to enjoy a home with more square footage, both indoors and out, as well as better fixtures and nicer amenities for the same monthly payment as a smaller or less-updated rental property.
If you’re thinking of starting a family soon, then this extra space could become necessary. Or, if you’re by yourself and simply want more room, you could take on a roommate to help with the mortgage payment, thereby allowing you to channel that extra money into paying back your student loans and meeting other financial goals.
5. You have a low-interest student loan.
Student loans are typically the least pernicious types of debt compared to credit card debt and auto loans.
In general, student loan interest rates tend to be lower and the loans typically allow an extended repayment period. Student loans are also unsecured, which means that you don’t risk losing any personal collateral should you need to stop paying them for a certain time. Though you would want to repay $10,000 in credit card debt as soon as possible, $10,000 in student loan debt is typically not so bad to pay off at the minimum payment rate in order to free up some funds for buying a home.
Having student loans doesn’t necessarily put the kibosh on buying a home.
There’s no clear-cut right or wrong answer. There are strong arguments for buying a home right now, as well as equally solid arguments in favor of waiting. Base your decision on whether to pay off student loans or buy a house on your finances, priorities and goals.
Kristina Byas and Paula Pant contributed to this article.
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