Are you trying to decide to pay off your student loans before you buy your first home?
There is no one-size-fits-all answer to this big question. Student loan debt has gotten a lot of attention in recent years for good reason. The cost of higher education has grown out of proportion to the economy. At the same time, the income benefits of having a college degree are statistically indisputable. So how do you make the investment in yourself without sacrificing your future wealth? For those of you who are not yet in college, I would suggest you seriously run your numbers before you sign onto a school with high tuition costs. Will there be a return on that investment? If you are already out of college, possibly even grad school, and the student loans are already an appendage, you will have to deal with it. For the purpose of this article, I will assume that you have no other debt than the student loan. Considering the easy access to credit I know that many fresh college grads and young professionals are in debt up to their gills. You got your first professional job and the salary felt pretty sweet compared to college days. You went out and got a nice apartment, bought a car on credit, and then racked up debt on credit cards because you really can’t afford all of your monthly bills. Herein lies a dreadful trap that many people fall into. If that is you, homeownership could be years away and the start of wealth building will be pushed out a few critical years. Check out my other blog for debt reductions tips.
I will address this article to young college grads who already have their first or second professional job and no other debt besides their student loan. Your dilemma is that you know you want to start building your wealth by buying your first home but you won’t qualify for as much home if you have student loans. Also, you may not be able to save as much for the downpayment and closing costs (we will call this cash to close) which will also limit the amount you can spend on a home. So you reason that you should pay off your student loans before you save for a home. Maybe you even move in with family members to lower your cost of living so you can knock out the student loans much faster.
That could be a good plan, however there are a few downsides. The cost of homes keeps rising, and by the time you are ready to purchase you are priced out of the market. If you elect to pay the minimum on your student loan each month and pack money into your house savings account you will be able to buy a home, but by the time your lender calculates your available income to make a mortgage payment while still making your monthly student loan payment, not to mention your other living expenses, homeownership could seem unaffordable. So what’s the answer? It lies somewhere between totally paying off student loans first and only making the minimum payment and depends on several factors.
How much student loan debt you have.
Your monthly payments on student loans.
What your income is.
Where you live (i.e. cost of living).
One thing to consider is the fact that rent payments are almost always comparable to the cost of a mortgage payment. Obviously, the benefit of homeownership is considerable over renting, so your goal should be homeownership no matter what. Once you get into your first home every payment to your mortgage increases the equity in your home. Ideally, the marketplace adds even more equity giving you a vehicle to buy up one day for even more wealth building. Renting does none of that. The student loan debt is what it is and paying it down as scheduled will not cost you any more than you signed up for. Of course, paying it off sooner will save you lots of money, but not compared to the benefit of equity in your own property. Look at the increase in value of homeownership over the past ten years in your area. The national average is 3.5-3.8% per year, but this rate has been much higher (10-15% per year) over the past three years. While there is no guarantee with any investment, including real estate, you know you are losing money renting. So it would be infinitely better to focus on saving to own vs paying down your student loans faster. It could even make sense to take advantage of a student loan forbearance program for one year to save a downpayment for a home. Another nice option is a state program. Most states have first-time buyer programs and even first-time buyer programs with student loan payoff benefits.
I am a realtor in Maryland so I will use this state as an example. If you do not live in Md find a good real estate agent who can refer you to a good lender who will guide you on programs in your state. Maryland offers a student loan payoff program which I have used several times for my clients. To take advantage of this program you have to have at least a 720 credit score (ouch!!). By contrast, FHA requires only a 640 credit score. Here is how this program works. The max the program will pay is $30,000 and you have to bring the balance of your student loan debt to settlement. So, if you owe $50,000 in student loans you’d have to bring $20,000 to closing. Wow, that seems kinda counter-productive to offer a program of which no one can take advantage! But, there might be a way. My last client had exactly this scenario. But she also had $50,000 in a 401K through her work. It would have cost her a total of $72,000 at $630 per month (8% interest on her loans) to pay off her student loans in ten years. Alternatively, she borrowed $20,000 from her 401K to buy a home (that’s allowed) and has to pay it back to herself at 4% interest over a ten year period for a monthly cost of $200 with a total interest of $4200 (which actually goes into her own account so the “opportunity cost” was eliminated). So her monthly costs on the student loan vs the 401K payback is $430 lower giving her a higher qualifying mortgage loan which translates into a more expensive home. She saves $22,000 in interest on her student loan and pays $4200 in interest on her 401K to herself. That is a huge win especially when you consider the wealth-building she is now gaining as a homeowner.
Another recent client had $40,000 in student loans and was able to borrow $10,000 from her parents to bring $10,000 to closing. If you owe $30,000 or less in student loans the SmartBuy 3.0 student loan program is a no-brainer. There are some downsides. The interest rate is .5-1% higher however, as of recently, you can refinance your home six months after settlement to a lower interest rate. If you took advantage of the $5,000 in closing help that accompanies the program, you’d have to pay that off at the re-fi. There is also one more caveat, if you sell the home within the first 5 years you will have to pay back the remaining student loan amount. The student loans are “paid off” by the program at 20% per year. So if you sold your home after three years you’d have to reimburse the program for 40% of your loans. You’d want to know that you will own the home for 5 years. But even with the restrictions and higher interest rate, the $30,000 benefit is hard to beat.
Another downside is that these loans are tricky and labor-intensive for lenders and few do them. A good agent will be able to refer you to a high-quality lender who cares about the people they serve enough to put up with doing these loans. When you submit an offer to purchase you have to state the loan you will be using, some listing agents might not love this program because they are justifiably afraid the transaction will not make it all the way to closing. I overcome this objection by assuring the listing agent that my lender is more than competent and that I have successfully used the program many times. I encourage the listing agent to contact my lender and feel her out on this program. Additionally, you have to put in a strong offer to get any home, but you may have to come in even stronger to win with a loan program like SmartBuy 3.0. Again, this comes down to having a good agent who knows how to balance winning the property with serving the buyer’s needs. This can be a tough needle to thread.
I encourage anyone strapped with student loans to put your primary focus on home buying so that you have a way to take two steps forward (wealth-building through homeownership) even as your student loan payments might feel like one step back. You have to sit down and crunch your numbers. The first step is to talk with a good realtor and or lender about your credit, debt to loan ratio, cash on hand, and how much you can qualify for. That information will let you know how much you need to save before you can buy.
Also, keep in mind that your student loans were an excellent investment in yourself and ideally your income-earning potential long-term. Be proud of your college degree and be thrifty with your money for the big win - HOMEOWNERSHIP.
By Lori Jean Buongiovanni, Realtor, ReMax 100, Maryland