If you’ve got student loans, you’re not alone.
The situation is especially dire among recent college graduates. According to a recent survey that I conducted, nearly half of Americans aged 21-29 have student loans, with a median loan amount of $25,000.
Not surprisingly, many people make paying off their student loans a top financial priority once they start working.
Additionally, 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 at the combined monthly payments of all of your debt, including student loans and your prospective mortgage. They 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 yet earn a lot, 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).
In this situation, 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 and reduce your student loan payments by refinancing at a lower interest rate. That’s a tall order.
Let’s assume that you’re not in this situation, though. Let’s assume that you earn enough to 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 that 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.
Though I don’t think that there’s such a thing as “good debt”, both student loans and mortgages let you buy things that will hopefully yield a positive return on your investment: Your education may allow you to earn more, while 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 rates on other kinds of debt.
If you get a mortgage at four percent, have student loans at five percent and are an aggressive investor, you might hope to invest additional money in the stock market and earn an average annual return of six or seven percent. This would net you a one or two percent return on your money, despite your debt.
The notion of using a mortgage to help you put more of your money to work in the stock market faster is so powerful that some people think you should always have a mortgage… Even if you have 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 eventually 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.
However, think about all of 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 a new home 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 that 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?
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 to your other debt.
If you earn $3,000 a month before taxes, let’s say that you actually take home 80 percent of that ($2,400).
If you were approved for a mortgage based on a DTI of 45 percent, that means that 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. Additionally, 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 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 article originally appeared on WealthPilgrim.com and was syndicated by MediaFeed.org.
Featured Image Credit: DepositPhotos.com.
