If you’ve got student loans, you’re not alone.
And among recent graduates, the situation is especially dire: Nearly half of Americans aged 21-29 have student loans, with a median loan amount of $25,000, according to recent survey I conducted.
Not surprisingly, many people make paying off their student loans a top financial priority once they start working. And along with saving an emergency fund and beginning to invest for retirement, buying a home is another often-cited goal for 20- and 30-somethings.
So here’s an interesting question: Should you try to pay off your student loans in full before you think about buying a home?
In some cases, you may have to. That’s because when mortgage lenders calculate how much home you can afford, they look the combined monthly payments of all of your debt – your student loans and your prospective mortgage. Then divide that number by your gross monthly income. The resulting number is called a debt-to-income ratio (DTI). And, for the most part, banks want to see this under 40 or 45 percent.
If you don’t earn a lot yet but have a big student loan payment, this could make it difficult or impossible to get approved for a new home loan. For example, if you earn $3,000 a month, have $1,000 in student loan payments, and want to purchase a home that would have a $1,000 mortgage, you wouldn’t qualify…your debt to income ratio is too high ( $2,000 / $3,000 = 67 percent).
Neal’s Notes: The higher your credit score, the more likely it is that the bank will grant you a loan. While adhering to the Debt To Income ratios, it’s still important to have the cleanest credit report you can. Even if you think your credit history is spotless, it never hurts to check.
In this situation – in order to buy a home — you would have to:
– Earn more money
– Apply for the loan with a co-applicant with a good income
– Pay off your student loans
– Reduce your student loan payments with an income-based repayment plan
– Reduce your student loan payments by refinancing at a lower interest rate
But let’s assume you’re not in this situation. You earn enough that you could qualify for a mortgage despite your student loan payments. Should you take on more debt in order to buy a home?
Many people do.
Why you might want to buy a home, despite your student loans.
The reality is, student loans may take years – or decades – to pay down. Both student loans and mortgages are designed to allow us to afford good, but expensive, things – an education or a house – by enabling us to pay for them over many years.
Although I don’t think there’s such a thing as “good debt”, both student loans and a mortgage let you buy things that will hopefully have a positive return on your investment: Your education may allow you to earn more and your home will hopefully appreciate.
Another argument for buying a home even if you have student loans is that you may be able to get tax deductions for both your mortgage and some of your student loan interest.
Finally, the interest rates on mortgages (and some student loans) are low relative to other kinds of debt. If you get a mortgage at 4 percent and have student loans at 5 percent but you’re an aggressive investor, your might hope to invest additional money in the stock market and earn an average annual return of 6 or 7 percent, netting you a 1 or 2 percent return on your money, despite your debt.
Another Neal Note: I am not a fan of this strategy. If you can pay off a loan that costs you 5%, that’s a way to earn 5% with no risk. My vote is to do that rather than invest Pilgrim.
This potential to use a mortgage to help you put more of your money to work in the stock market faster is so powerful, some people think you should always have a mortgage…even if you had the cash to own your home outright. This strategy is not for everyone, but it’s food for thought.
Finally, your actual return could be even higher if your home appreciates and you can one day sell it at a profit. I don’t think you should count on this – you should buy a house to be your home first and foremost – but it’s a nice bonus when it happens.
Why you might want to wait
Here’s the thing: Buying a home is an ambition, not a necessity. There’s nothing wrong with renting!
The old notion of “throwing your money away on rent” isn’t as clear-cut as you might think. Yes, when you make a mortgage payment, you build equity; when you pay rent, you don’t. But think about all the additional expenses involved in owning a home: Taxes, insurance, and maintenance. I can’t think of anybody I know who hasn’t moved into their new homes and –despite having home inspections — discovered one or more issues that cost $1,000 or more to fix.
On top of that, houses tend to be bigger than apartments, and we immediately develop an emotional attachment to them. That means you’ll likely be tempted to spend more to furnish and decorate a house than you might an apartment. Add up all these costs, and that’s a lot of money saved that could be used to pay off your student loans.
So which is it? Some final advice
I think the decision to postpone buying a home until you’ve paid off your student loans comes down to one thing: Can you afford both, or not?
Let’s go back to the debt-to-income ratio. A bank might approve you for a mortgage at 45 percent debt-to-income ratio. That means that 45 percent of your gross – before tax – income is going to either your housing or your other debt.
If you earn $3,000 a month before taxes let’s say you actually take home 80 percent of that, or $2,400. If you were approved for a mortgage based on a DTI of 45 percent, that means your combined monthly mortgage and loan payment is $1,350 (45 percent of $3,000). But that’s actually 54 percent of your take-home pay. And it leaves you with $1,050 a month for everything else: Food, utilities, your car and savings.
This is a classic example of “just because the bank approves it doesn’t mean you can afford it”. This is the time to roll up your sleeves and rid yourself of student loan debt as fast as possible. You might even be able to get it done in as little as three years.
If, however, you earn enough or buy a modest of enough home that your debt to income ratio would be closer to 30 percent, you have a better shot at affording both your mortgage and your student loan payments in the long run.
This is a guest post written by David Weliver from MoneyUnder30.com. His blog is one of the best resources for young people trying to get on and stay on the right financial path. I strongly recommend that you check his site out.