Katy mentors and educates young professionals and helps those beginning their careers and financial journeys to make informed decisions.
Pay Off Student Loan or Save for Mortgage?
Many young Americans are graduating college with student loans that take years to pay down.
A common question is: Do I put my paycheck towards paying off my student loans or accrue savings for a down payment on a house?
With enough savvy financial skills, it's actually possible to do both!
Follow these three steps to get on track for saving for a down payment while paying down student loans. It's a balancing act that requires you to thoroughly understand your financial situation, your options, and your priorities.
Step 1: Get Your Loans in Order
The first step towards saving for a house while paying down debt is to get your loans under control. This step will alleviate the uncertainty and fear that comes with debt. After you complete this step you will know what needs to be done for your loans and won't feel like they are holding you back from your financial goals.
Talk to your lender or log on to the account website to gather all of the following information:
- The total principal remaining on all your loans
- The interest rate and principal of each individual loan
- Your repayment options (regular, income-based, etc)
All this information is best kept in a notebook or a file on your computer where you keep important financial information. You will refer back to it throughout your journey to controlling your debt and buying a house.
Pay Towards the Highest Interest Loan First
You will decide in later steps how much money to add to down payment savings vs loan repayment. But regardless of the amount dedicated to students loans, put all of it towards the loan that has the highest interest rate. The reason here is simple: paying down the highest interest loan will save you interest in the long run.
Step 2: Evaluate Owning a Home vs Paying Off Student Loans
Think about what you will gain financially and emotionally by owning a house. Also consider how paying off student loans sooner will help you, both financially and emotionally. Consider your specific situation and start to weigh both options.
Benefits of Owning a Home
Owning a home with a mortgage instead of renting can sometimes mean a lower housing cost in the right circumstances. Also, that money you are paying for housing goes into an asset instead of to a landlord.
But probably the biggest benefit of home ownership is the emotional side. It allows you to do what you want with the place you live in. This can have a huge philosophical benefit for some people.
Think about what you will sacrifice by waiting longer to buy a house. Will you have to move to a new place to avoid rising rent? Are housing prices rising drastically? How much will it affect your long-term happiness and financial well-being to wait a few years? Honest answers to these questions will help you assess where your savings should go.
Benefits of Paying Off Student Loans
When your loans are paid off the required payments stop and you stop paying interest on them. You also have that debt erased from your credit report.
Taking a slower approach to paying off your loans (ie, smaller payments) means you end up paying more in interest. Otherwise, having a student loan account on your credit isn't usually viewed negatively by credit card lenders or banks evaluating you for a car loan. It's a relatively "harmless" type of debt for lenders as long as you are current on payments.
The psychological element to being debt-free is important also. If you have student loans you've likely been in some form of debt for your entire adult life, imagine how great it will feel to be free!
Long-Term Financial Strategy
Remember while you're evaluating your options that this is long-term commitment. Both paying down loans and saving for a down payment are things that usually take years.
The other side of this is that it's perfectly okay to change your direction later. Personal emergencies or changes in financial priorities happen. Focus on making the best decision for yourself right now and working towards it. It will set you up to be in a better position later if you do change your mind.
Step 3: Save For a Down Payment While Making Loan Payments
Once your students loans are well understood and you understand your financial priorities you can start thinking about how much you can save for a house. If you're contemplating this choice then you have excess income that is currently going to students loans that you are now wanting to shift to a down payment savings account.
When to Switch Your Savings from Student Loan Payment to a Down Payment
The best time to switch from paying down loans to saving up for a down payment is when every dollar you save towards a down payment helps you more than that same dollar going towards loans. For most people this is only the case when the high interest loans (loans with interest rates above 5%) are paid off and the principal is low enough so that the interest is no longer a burden.
Keep Student Loan Minimum Payments on Auto-Pay
No matter what you decide for down payment saving keep paying at least minimum amount on auto-pay. There are discounts for setting up a monthly auto-pay from most major lenders.
Also, it will keep you on track to pay off your student loans in a reasonable amount of time even after the home is purchased.
Put the Extra into Down Payment Savings
Whatever extra you were previously putting towards your loans beyond the minimum required payment, you can start putting that aside in a savings account for a house.
How Student Loans Affect Your Credit When Qualifying for a Mortgage
This is not an explicit step to take when shifting your finances to saving for a house but it is important information to understand when making short to medium term decisions on students loan payments. An open student loan account will affect the credit score and credit history that banks look at when deciding what mortgage rates you qualify for. If you want more information about credit scores beyond student debt, read more on FICO scores.
Income to Debt Ratio
Even if you have met every required payment deadline with your lender, the amount of money you owe will increase the total debt the bank sees when they examine your credit. Student loan debt is seen much more favorably than credit card debt because it’s a lower interest rate and you have a long time span to pay it off.
But it is still a liability that the bank knows you will have to continue to make payments on so they will be examining it. The bottom line here is the lower number the better.
Age and Types of Accounts
If you are a first time home buyer and have never had a car loan, then credit cards and student loans are likely the only types of loans you have dealt with.
Also, since most people with student loans started borrowing at the age of 18, your student loan account is likely one of the oldest accounts in your credit file. Closing an old account means your average age of accounts will go down making your credit history look less reliable and lowering your score.
Should I Pay Off My Student Loans Before Buying a House?
Do your loans need to be completely paid off before you buy a house? Not necessarily. With the right emergency fund and income, people who are savvy with money can leverage debt to their advantage.
As you learned, closing your student loan account has varying impacts to your credit score but it might not be deal breaker for mortgage qualification if you already have strong credit. Certainly, avoiding a dip in your credit score is not a reason to not pay off the loans if you are able.
Buying a house with a small principal remaining on their student loans is the right answer for many people. These are the people who have control of their finances, understand the commitment of home buying and have a plan to aggressively pay off their debt.
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.
© 2018 Katy Medium