Should I pay off all of my loans before I try to buy a house?
February 26, 2011 5:12 PM   Subscribe

I need some house buying help, and advice about whether to pay off my loans now or save more for the down payment.

I'm 30ish, single, no kids. I earn a good living (~$60K/yr), and while my job is very stable and secure, my income is not likely to increase significantly in the future.

For the past year I have been really, really wanting to buy a house. I clamped down on any extra expenses and have saved about $20k. My retirement accounts are fully funded, and I wouldn't use them to buy the house.

I owe about $5k on a student loan (5% interest) and $12k on a car loan (7% interest). Looking at my savings and those loans, it occurs to me that I could pay them both off today. BUT, then my emergency fund/down payment fund would be severely depleted.

I'm feeling a little paralyzed by this and don't want to make the wrong move. I would appreciate any advice or suggestions. I'm happily renting for now and learning about the housing market in my area. I am very happy in my job and city and will definitely stay at least five years, likely more. No plans to meet or marry anyone or get any kids anytime soon.

Advice? Book recommendations? Ideas? Reassurance?
posted by anonymous to Work & Money (14 answers total)
Pay both off, your mortgage affordability is calculated on how much you have left over on a month to month basis, and you'd be surprised how detrimental an effect having even small monthly credit commitments are, even if they have less than a year to run.

I am a former financial adviser.
posted by dougrayrankin at 5:26 PM on February 26, 2011

You saved the $20k in a year? If I were you I would pay off the debt (or even just the car loan) and then build up your savings again. It doesn't seem like it makes financial sense to be paying interest on a debt when you have cash in hand to pay it off. And those debts may make it difficult to get a mortgage.
posted by apricot at 5:29 PM on February 26, 2011

I see two relevant thresholds: you need in cash a 10% down payment (or 3.5% for an FHA loan) plus say 5% for closing costs and to demonstrate a cushion to your lender. Also, your car and student loan payments plus the expected amount of your mortgage/escrow can't exceed some fraction of your income (varies depending on the loan). In my opinion, your concern should be making sure you'll be above both thresholds by the time you're ready to buy. To get beyond the first threshold, save more cash, to get beyond the second either pay off a loan (starting with the student loan is reasonable if its monthly payment is large enough to disqualify you from getting a loan) or plan on a smaller house.

If you think you're already beyond both thresholds, which is possible if you're thinking modestly, it may not matter a whole lot in terms of your ability to get a loan what you do. Once you do get there, paying off the higher interest loan first will probably be optimal.

I was in a similar position to you at this time last year (single, 30ish, bought a house in May 2010). I had modest car debt; as it was at 0% interest and my income is high enough to cover my monthly debt payments, including mortgage, it made no sense to pay it off early, and I had no problem getting a mortgage with that debt. Really all comes down to those two thresholds plus a stable income.
posted by deadweightloss at 5:39 PM on February 26, 2011

pay off the debt with your savings and save some more for a downpayment
posted by webwesen at 5:39 PM on February 26, 2011

How long would it take to get under contract? (In a competitive place, it could take a long time to find something (a) you like (b) more than the other bidders.) Home buying is a process, one that is educational and can take some time. I'd keep saving aggressively but keep it liquid so that your options are open. See what purchase price you qualify for, start looking for a house, and then try to buy something cheaper than you can afford and use part of the money to pay down the loans.

Keep an eye on mortgage interest rates.
posted by salvia at 5:53 PM on February 26, 2011

Someone will correct me if I'm missing something, but I was in a similar situation, and I ended up putting down a huge down payment. Paying off your student loan seems like a good idea to me, but paying off your car loan does not. Your car loan -- again, if I've got this wrong, I'm sure someone will chime in -- will cost you the same $12K today as it will in four years (or whenever). The $12K includes the interest, and you don't have an option to pay off principal early to reduce the amount of interest you'll pay, the way you can with other loans (including your mortgage, if you have no prepayment penalties). In fact, paying off your car loan in full now is a waste of an opportunity; you can keep the $12K and earn interest on all but the $300 or whatever you pay each month.
posted by troywestfield at 6:02 PM on February 26, 2011

Your car loan -- again, if I've got this wrong, I'm sure someone will chime in -- will cost you the same $12K today as it will in four years (or whenever). The $12K includes the interest, and you don't have an option to pay off principal early to reduce the amount of interest you'll pay, the way you can with other loans (including your mortgage, if you have no prepayment penalties). In fact, paying off your car loan in full now is a waste of an opportunity; you can keep the $12K and earn interest on all but the $300 or whatever you pay each month.

This is not the case for normal car loans in the US, except for some crappy sub-prime loans. Regular car loans can be paid off at any time, saving you the interest that would have been paid had you paid it off slowly. Read the paperwork carefully, though, to be sure you don't have prepayment penalties or other barriers to doing this.
posted by Forktine at 6:14 PM on February 26, 2011 [1 favorite]

I'd like to offer a different analysis: what are you planning to do with the house? I'm a single homeowner, and from this side of the fence, I'd advice you these things:

1. Owning a house to live in is a costly expenditure. A house has mortgage, insurance, tax, and maintenance, all of which are costly. On top of that, you are taking a risk of staying fixed (i.e, you can't move) and illiquidity (you can't access your savings as easily). But you get a lot more living space per housing dollar you spend, plus a chance to build equity on a leveraged asset (housing appreciation is based on total value of the house, of which you only own one small part).

As a single man, I'd argue that I don't need that much house/living space (you maybe different). A married couple is the right type of customer for a house because they get a lot of use out of it: to enjoy a shared domicile and to raise children. Me, all I really need is my bed and my computer desk; shared access to bathroom and kitchen are fine. So, to live in a house as a single person is an unnecessary luxury to me.

2. But, you can own a house as a investment. If you want to do this, treat this as an investment. First, do you want to be a landlord? It'll require some time, education, and certain risk. If you want to be a landlord, figure out how you can successfully buy a house; keep it up; find a tenant; and generally operate the house as a business. Do some research. Take some real estate class. Read a book or two.

Housing as an investment has some distinct characteristic: a. It's illiquid: slow to buy or sell, and costly too. b. It's an active investment: you have to look after it, do maintenance, screen tenants, service call from tenants, etc.. c. It's leveraged: a large part of the cost of buying the house came from the bank. That means interest, insurance. That also means you must have enough saving to pay the mortgage if your house is empty; and to pay for fixing things. The upside is if the house appreciate, you get to keep all the gain (from both your share and the bank's share), the downside is if the house depreciate, only you will lose money.

Due to those distinctive characteristic, real estate investment is different from stock or bond. It's not comparable at all. But it does have its nice characteristics. You can park your saving in a rental property and maybe one day, retire on its income. It's a sweet way of having your own side business.

So, if you feel like the money you have is burning a hole in your pocket, investigate this investment vehicle. One thing I may want to contradict others about paying off the loans is that: if you are going to buy a house, it's may not be advantageous to pay off all your loans. Yes, having fewer current loan will allow you to qualify for a higher mortgage. But if you happen to fall into a situation when you need money (vacancy, job loss, etc..) having a big saving is nice. It's better to keep $30k in the cash saving to pay the mortgage during these situation than to increase the down payment by $30k and reduce your loan. Yes, you will have to pay more in interest, but you will have more financial safety. Consider the extra interest payments as buying you peace of mind.
posted by curiousZ at 6:38 PM on February 26, 2011 [1 favorite]

Pay it off now.

But this is key: continue making the "car payments" into a separate account, so that when it comes time to buy a new car, you will have a down payment AND you will be used to making the payments. You would not believe how easy it is to not have a car payment and to find that the extra money finds a use somehow.
posted by gjc at 7:04 PM on February 26, 2011 [1 favorite]

It depends on a number of factors. You'll really really want your first mortgage to be no more than 80% of the purchase price. Ideally, you'd put 20% down and pay cash closing costs. Mrs. VTX and I are in the middle of buying a house right now (just got the final approval on the mortgage and we're just waiting for the closing). The purchase price is $172,000 and 3% of that consists of seller paid closing costs. We're putting 20% down and still have some closing costs to cover so have to bring about $36,000 to the closing.

By getting down to 80% of the purchase price, you avoid private mortgage insurance (PMI). This is an extra charge that you get to pay so that the lender will get paid if you default on your loan. You start out with less equity and less skin in the game so you're considered a higher risk loan (though why they don't just charge a higher interest rate and buy their own insurance is beyond me). If you go for an FHA loan, you always have to pay PMI even if you put 20% down (though the premium is lower). Had we gotten an FHA loan, PMI would have added another $115/month to our payment.

There is also such a thing as an 80/10/10 loan. You have a first mortgage for 80% of the purchase price (with a rate around 5% as of today), and 2nd mortgage for 10% (at a higher rate), and 10% down. This gets you around having to pay PMI. In your case, you'd probably be better off with FHA since this would be your first home.

So the first question is, how much house do you want to buy and how much will it cost?

Between the those two loans and your income and judging by how much you saved in just a year, paying off the loans is probably not going to be about being able to afford the monthly payment. I really doubt you'll have any trouble getting an approval for a loan but again, it depends on much the your want to buy costs.

I wouldn't worry too much about depleting your savings to buy the house. You'll want to have a little bit in the bank in case something comes up with your new house and you can bet that there will be things you didn't think of. Your job is stable so if a real financial emergency happens short term you could use credits cards or, since you'll likely have some equity right when you move in, you could get a home equity loan or line of credit. Either of those scenarios sound highly unlikely so long as you can build up your savings again in short order. As long as you have access to lines of credit (credit cards at the least), you're usually better off paying off debt even before you build your savings back up.

What you're really after the way to pay the least amount of interest overall. Since your student loan rate is so low and is pretty close to current mortgage rates especially since that interest is tax deductible, I'd leave that one alone whether you buy a house or not.

Even with an FHA loan and PMI, You're not going to get close to 7% APR (which is different than the rate as it includes the total cost of borrowing) so I'm leaning towards paying off the auto loan. Even if you don't do it until after you buy a house, I'd probably work on paying off the auto loan before I worried about my savings so long as I had access to lines of credit. You almost certainly won't need to use the emergency funds so any money that you put back into savings is money that didn't pay down the auto loan and ends up costing you more money in interest.

It might also work for you to buy a house and lease a room to a friend or something. Don't buy a house with a friend and write up a real lease if you want to stay friends but it might work for you as long as you make sure you buy a house you can afford if you live in it all by yourself.

Before you do anything, go talk to a mortgage consultant at your bank. They'll know a lot more about the terms of the loan programs available and have nifty calculators that will let you look at the costs of a bunch of different scenarios.

TL;DR: Go to your bank, talk to a mortgage consultant.
posted by VTX at 7:34 PM on February 26, 2011 [2 favorites]

Regarding mortgage insurance, I'll point out mine costs me $28/month after the tax deduction, on a $168K house. I do not think it's worth "stretching" to avoid paying PMI. Indeed, for a first house, you will probably get more value out of the extra liquidity than you will from not having to make a PMI payment.

That said, I have a conventional loan; it's worse with FHA as they want a large lump sum up front (I will be out of my PMI through normal payments after a little more than 2 years). For me, it was worth compromising liquidity to get a conventional loan instead of an FHA loan.
posted by deadweightloss at 7:58 PM on February 26, 2011

If you go for an FHA loan, you always have to pay PMI even if you put 20% down

This is only true in a very specific circumstance (buyer forgoes payment of the upfront premium) that would probably never happen to anyone with more than the absolute minimum amount of liquidity to get an FHA loan. It's technically possible but in most cases you get to stop paying PMI once the loan-to-value of your mortgage reaches 78 percent of the initial sales price or the appraised value of your home, whichever was lower.

We bought a house on and FHA loan last year and you had me scrambling to verify what our mortgage broker told us. Never can be too careful...
posted by the christopher hundreds at 8:01 PM on February 26, 2011

I'm going to go against the grain: don't pay off your debt now. Go get the house.

Debt has never been harder to accrue (due to meager bank lending) and cheaper to maintain (due to low interest rates). If you can get debt, now is the time to get it. If you think the economy will be worse off in the future (which it will be) then the "price" of your debt will be far cheaper down the line. As long as you're maintaining your monthly payments, your credit rating for loan eligibility should be fine. Yes, you'll get a smaller loan because you'll have less discretionary money per month to spend, but how much house do you need?
posted by Civil_Disobedient at 11:19 AM on February 27, 2011

Your mortgage interest rate is likely to be around 4-5% if you buy some time in the relatively near future. I would pay off the 12% car loan, or maybe a large chunk of it if you won't have enough left for a down payment (assuming there's no penalty for prepayment and that you don't have to pay future interest that hasn't been accrued yet), and then buy the house. Your mortgage will be larger because you spent money on the loan, but your total debt will be the same, just at a lower interest rate.
posted by chickenmagazine at 12:38 PM on February 27, 2011

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