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Should You Pay Off Student Loans or Buy a House?
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Many people see owning their own home as a key financial goal. But if you have college debt, which should you do first: pay off student loans or buy a house?
There is no one right answer that applies to everyone. When deciding whether it’s better to pay off student loans or buy a house, consider your current financial situation, the state of the housing market in your area and your other priorities.
It’s a common question: “Should I pay off student loans or buy a house?” If you’re struggling with the idea of buying a home because of your debt, here are some scenarios where delaying homeownership may make sense:
To determine whether you qualify for a mortgage, lenders review how much of your monthly income is devoted to debt — including student loans, car loans and credit card payments. How much of your income that goes toward your debt is reflected in your debt-to-income ratio (DTI).
To calculate your DTI, add up all of your debt payments every month. Divide that total by your monthly gross income — the amount of money you make each month before taxes and other deductions are subtracted. Multiply the resulting number by 100 to get a percentage to get your DTI. For example, let’s say you earn $4,500 per month and have the following debt obligations:
|Credit Card #1||$150|
|Credit Card #2||$50|
|Total Monthly Payments||$850|
If you divide $850 — the total you apply to debt each month — by your income, you find that your DTI is 18.9%.
The Consumer Finance Protection Bureau (CFPB) recommends that mortgage borrowers should maintain a DTI of 36% or less. However, some lenders will allow up to 43% or even higher. But that doesn’t mean you should apply for a mortgage; taking out a loan when your DTI is high may stretch your finances too thin.
If you want to buy a house but have too much debt, you can use these tips to reduce your DTI:
- Refinance your student loans: If you refinance your student loans, you may qualify for a longer repayment term or a lower interest rate and reduce your monthly payments. With a smaller payment, you can improve your DTI.
- Apply for an income-driven repayment plan: For federal loan borrowers, you could potentially reduce your payments and DTI by applying for an income-driven repayment (IDR). These plans base your payments on a percentage of your discretionary income and a longer loan term.
- Pay off debt: If you have other types of debt, paying off the accounts with the smallest balance can help you lower your DTI faster. When you pay off a credit card or loan, you eliminate that monthly payment, reducing how much of your income goes toward debt.
- Boost your income: If possible, you can lower your DTI by increasing your income. Some options include getting a raise, applying for another job or taking on a side gig.
Traditionally, experts recommend saving for a down payment of at least 20% of the home’s purchase price. A 20% down payment can make your mortgage more affordable, and you wouldn’t have to pay private mortgage insurance (PMI).
A LendingTree study from 2021 showed a 20% down payment on the average U.S. home would total $15,023. But even that sum would be low for many major real estate markets. For example, the median home price in Seattle is $503,000, for which a 20% down payment would run $100,600. In San Jose, the most expensive housing market in the country in 2021, the equivalent 20% down payment would be $223,280.
Depending on your situation and credit, you may be eligible for a conventional mortgage with as little as 3% down. However, the lender will likely charge you a higher interest rate since you have a smaller down payment — plus, you’d also need to pay PMI.
PMI rates can change over time. According to the Urban Institute’s 2021 report on mortgage insurance, PMI generally costs between 0.58% and 1.86% of the loan amount each year. Depending on the size of the mortgage you need, PMI could significantly add to your cost.
|Is it a bad idea to buy a home if you don’t have 20% down?
Again, it depends…
|● The price difference between the total cost of homeownership (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%. Our rent versus buy calculator can help you figure out the price differential by factoring in variables like 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. The National Association of Realtors NAR) reported that the median sales price of existing homes increased by 13.4% between June 2021 and June 2022. When prices rise more quickly, it can make more sense to pay PMI for a mortgage because the fast appreciation in property value can help offset this extra cost.
● Your personal financial situation. The state of your finances, 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) can affect whether it makes sense to buy a home right now or not.
Homeownership requires more than simply paying a mortgage each month. In addition, you’ll need to plan for maintenance and unexpected repairs that renters don’t need to worry about. For example, these are just some of the common problems you may encounter:
- The roof starts leaking
- The furnace breaks
- The air conditioner needs to be replaced
- The gutters need cleaning
- The deck needs to be refinished
- The hardwood needs another coat of polyurethane
- Feeling exhausted, yet? Your bank account will be.
Ensure that you have enough room in your budget to absorb these potential additional costs, not solely the cost of mortgage payments. Experts recommend setting aside 1% to 4% of the home’s value for repairs and maintenance. The best way to meet this demand is by purchasing a less expensive home than the maximum you’re approved for.
Renting gives you the flexibility to change careers and move to new cities on a whim. Homeownership drastically limits that kind of freedom.
Sure, you can always sell your house — but that can pose plenty of risks, hassles and transaction fees. And if you sell the house within one or two years, you may also have to pay capital gains taxes.
You could also rent out your house, but you may not want the responsibility of being a landlord.
Plus, selling your home only a few years after you bought it can be costly. According to research released by Betterment, it takes about four years of living in a home after its purchase to break even. If your job is unstable, you’re contemplating a major career or lifestyle change or you’re just not sure where you see yourself in the next few years, it may be a better idea to rent for now.
People may tell you that you’re pouring money down the drain when you rent, but there’s no need to rush into homeownership. Your monthly rent gives you a place to live, and it may even be more financially savvy than buying a home right now.
If your finances are out of shape or you’re not sure of your long-term plans, then it’s OK — 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 — not everyone does! In addition, the factors in your personal life — your family, your relationships and your commitment to a specific location — must align with the goal of homeownership.
If you want to become a homeowner, consider these scenarios where buying a house before eliminating your debt could be a smart idea:
If you have a low DTI, such as 35% or less, that’s a good sign you can commit to a mortgage while still being able to pay back your student loans responsibly. A low DTI indicates that you can comfortably afford your current debt payments, a mortgage and still have some money left over for savings and planning for retirement.
Buying a home requires a significant amount of cash. Besides a down payment, you will also need money for closing costs, and lenders will want you to have cash reserves to show you can manage your payments. You also need to consider an emergency fund, money for repairs and maintenance and moving expenses.
If you have enough money saved in the bank to cover those costs, you’re in good shape and can likely afford to buy a home.
According to researchers at Florida Atlantic University, in some metro areas — including New York, Boston and Chicago — buying and establishing equity is a better way to build long-term wealth than renting.
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.
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.
Being financially ready to be home is critical, but you may also be primed for personal reasons:
- You’re thinking of expanding your family: If you plan on having children, you may want a larger home so you can have a nursery.
- You want space for pets: You may want to adopt a pet, but your landlord doesn’t allow them. Or you may want a house with a yard so your dog has room to explore.
- You work remotely: With many people transitioning to remote work, you may be looking for a house to get more space for a dedicated office.
If you end up with a home with more space than you need, you could get a roommate or rent out unused space to earn extra money to put toward your student loans and other financial goals.
Compared to other forms of debt, such as credit cards and auto loans, student loans typically have lower interest rates and more favorable repayment options. In the past, student loan interest rates were as low as 2.75% for federal loans. Plus, your student loans may entitle you to a valuable tax deduction — with the student loan interest tax deduction, you may be able to deduct $2,500 or the amount of interest you paid toward your loans, whichever is less.
Though you would want to repay $10,000 in credit card debt as soon as possible because of how quickly interest can accrue, $10,000 in student loans is typically easier to pay back. Paying only the minimum to free up funds to buy a home can be a good idea.
Deciding whether to pay off student loans or buy a house can be tough. Everyone’s situation is different, and there are compelling arguments for both options. When choosing what’s right for you, think about your current finances, priorities and future goals.
But don’t let your loans discourage you from buying a home. You could purchase a house and pay down your student loans at the same time with these strategies:
- Adopt the debt avalanche method to attack higher-interest debt first.
- Consider student loan refinancing to lower your education debt’s interest rates, if you have good credit or a helpful cosigner. (Beware of refinancing federal loans, however.)
- Open separate savings accounts. When you earn extra money, split it up and deposit some into an account designated for a down payment. Deposit the remainder into another account for your emergency fund or other goals.
- Comb through your budget to cut unnecessary expenses that may be preventing you from paying off student loans or buying a house.
- Increase your income to improve your DTI even more.
And if you need more help making the decision, seek out financial help.