One of the search terms used to reach this blog was “pay off debt or save for house,” which got me to thinking. If you don’t have someone to help you with the down payment, is it better to pay off debt or save for a house?I think it depends on the type of debt, the amount of debt you have, your income, and your target home price.
Type of Debt:
If you have credit card debt or other high rate debts, you must pay those off before you can do anything else. Lenders frown highly on those debts when considering how large of a loan to give you. Not to mention that you’re just throwing away money by continuing to pay that interest. The most you can expect to earn on a savings account – which is where short-term house savings should be – is around 4%. That number could continue to drop if the Fed rate is cut further. If you save your money instead of paying off a credit card at 15%, you’re losing more than 10%.
On the other hand, if you have low-rate student loans (below 6%), then you should save for a house instead of pushing to pay them off. Student loans are considered good debt, so lenders look upon them more favorably. In addition, much of the time you can earn a better return on investments. And finally, those loans can be deferred or put into forbearance if times get tough. I plan to pay off our credit cards and two student loans before we attempt to get a loan, but we won’t wait to pay off our entire student loan balance because we have two graduate degrees between us and a lot of student debt.
Of course there is an exception to this policy. If you have a large amount of debt, say more than 30% of your income goes to debt repayment of any kind, then you need to start paying down debt. These days, most lenders will not issue a loan that will bring you above the 43% debt-to-income ratio unless you have a very high income potential (e.g. you’re a surgeon with medical school loans). So, even if your loans are low-rate, pay down the principal until your debt payments and expected housing payments are less than 43% of your income. With the new underwriting standards, more lenders are pushing for DTIRs of 36% or lower if you want the best rate. The higher your DTIR, the larger the down payment you’ll be asked to put down.
Another exception occurs when your income is higher than the amount you need to pay down debt and save for a house. In this case, you can either spend a few months shoveling all the money you can into your debt, or you can split your goals and pay towards each. I would choose the former, but the latter would also provide you with a nice emergency fund while you save for a house.
Target House Price:
Again, this goes to your debt-to-income ratio. In Los Angeles, home prices have now fallen to December 2004 levels, but that was near our peak, so they still have further to fall. If you live in a state like California where home prices are outrageous, then you need to work harder to pay down your debt so your debt-to-income ratio is manageable. It’s ideal to be below 33% DTIR total, with 28% max going towards housing. That may be nearly impossible for first-time buyers in California and other high-value states, but it’s a goal to work towards.
There’s no one right answer to the question, but once you consider your situation in light of the following factors, I think the best answer will be pretty clear.