If you're looking to buy your first home and are saddled with student loan debt, you may have a decision to make. Should you use your resources to pay off your student loans first, save up for a down payment or try to do both at the same time?
Saving Up First
Arguments for saving up for a down payment first include:
- Owning a home can be less expensive than renting and can provide emotional comfort in having your own place to fix up and remodel as you see fit.
- Housing prices, interest rates and the cost of renting will all likely continue to rise if you put off buying a home in favor of paying off debt.
- Buying a home can be a worthwhile investment. According to data from the National Association of Realtors, home prices have risen an average of 6.5% annually since 2015.
- Student loan debt is not as bad on your credit rating as other types of debt. That's because student loans have longer repayment terms and typically feature lower interest rates.
- Since your down payment will lower the overall cost of your mortgage, it may be more advantageous to save up money for a home than to pay off a low-interest student loan.
- You may qualify for student loan forgiveness or discharge through your job, a career change, volunteer work, an income-based repayment plan or even through the government's borrower defense statute if your college used illegal tactics to get you to borrow money. (For more see: How Long Should It Take to Save for a Down Payment?)
Paying Off First
Reasons to pay off your student loans first include:
- Paying off student loans means the debt is entirely erased from your credit report. While student loan debt isn't a huge factor in your credit rating, it is a factor.
- The longer you wait to pay off debt, the more interest you will pay. The higher the interest rate, the more you will save.
- If your student loan interest rate is variable, it will likely go up over time, costing you even more.
- There is a psychological effect to having debt. Some people prefer to go into the home-buying process debt free.
- Interest paid on student loans (up to $2,500 per year) is tax-deductible. (For more see: Student Loans: Paying Off Your Debt Faster.)
You may decide you can handle paying down your student loan debt while saving for a down payment on the home of your dreams. This isn't something to be taken lightly, but it is entirely possible if you follow some simple guidelines:
List All Debt – This includes car loans, credit cards, student loans and any other type of debt you have. Make note of the remaining principal (balance), interest rate and minimum monthly payment for each one.
Pay Off High-Interest Debt First – Pay as much as possible on the loan with the highest interest rate. Pay at least the minimum on all others. Once a debt is paid off, move to the next highest interest rate. This will save you the most money in the long run.
Put Savings in a Separate Account – Keep your down payment savings separate to avoid spending it. Open a savings account that pays the highest rate (online is best) or set up an investment account to increase your potential yield over time. Be aware, however, that investing is risky, and you could lose everything in a down market.
Don't Neglect Other Savings – You should have an emergency fund of three to six months income and retirement savings to round out your financial picture. Each of these is a separate account. If your job offers a 401(k) retirement plan, make sure you put enough in it to take advantage of employer matching.
Renegotiate/Consolidate – Consider refinancing or consolidating student loans to lower payments or the interest rate. Find out if you are eligible to convert to an income-based payment plan. Mortgage lenders will use your standard repayment plan to calculate your debt-to-income ratio (DTI) so lowering your payment may not help you qualify for a home loan.
Keep Paying Student Loans – Deferment or forbearance of your student loans is a bad idea. It may not hurt your credit rating, but interest will continue to accrue. Making regular payments keeps you on track to pay off your loans on time. (For more, see: A Motivational Strategy to Pay Off Debt.)
How Much You Need to Save
To obtain a conventional loan without private mortgage insurance (PMI), you will need a down payment equal to 20% of the selling price. If your down payment is less than 20%, mortgage insurance will add between 0.3% and 1.5% of the total loan.
Federal Housing Administration (FHA) loans require only a 3.5% down payment but come at a higher interest rate and require mortgage insurance. Once the equity in your home reaches 22%, the mortgage insurance can stop. (See also: Using Your Savings on a Mortgage Down Payment.)
These savings strategies may help you reach your savings goal sooner:
Save Automatically – Use direct deposit or automatic transfer from your checking account to move a regular amount to savings. If you treat saving as an ongoing expense, you will be more likely to do it.
Put Extra Money in Savings – Work bonuses, holiday gift checks, rebates and tax refunds can all go into savings. Avoid the temptation to spend that money, and you will realize your savings goal sooner.
Cut Expenses – Look for places to cut spending and divert that money into savings. Places to cut include entertainment, eating out, subscriptions, expensive vacations and clothing. If you rent, consider moving back in with your parents (with their permission, of course). Offer to pay something for room and board.
Get (Another) Job – Income from a part-time job that can be dedicated to savings will help you reach your goal quicker. You could also try asking for a raise at your current job or volunteering to work overtime. (See also: 5 Easy Ways to Save More Money.)
It's possible to save up to make a down payment on your first home while paying down student loan debt. You don't have to choose between the two. Keep in mind that circumstances change, and what is impossible now may be possible in a year or two. Re-evaluate your situation as needed and be prepared to alter plans as necessary. (For additional reading, check out: First-Time Homebuyer's Guide.)