Should we save for down payment or pay off our student loans?
June 11, 2007 12:20 PM   Subscribe

Should we save for down payment or pay off our student loans? and what about retirement?

My partner and I want to buy a house soon. He is a young professional and I am a grad student. We are both recent university grads and are working towards paying off our school loans. The interest rate on these is about 8% (it’s a private bank loan). I am confused as to how to divide up the little money we have between paying off the education loans, saving for retirement and saving for the downpayment. What is most logical money-wise? Not to save for either retirement or downpayment until we pay off the loans in full, because we are not likely to make more than 8% in anything else? But then it may take a while to pay them off (approx. $25,000 to go).

I heard that many people save for downpayment in ING savings account (if the purchase is less than 5 years away). ING savings account pays 3.5-4% in Canada, so it doesn’t seem to make much sense to do that, when we are paying 8% on our education loans. Is the better approach just keep paying off as much of education loans as possible, and then just take out the mortgage with zero downpayment? (The rates on the mortgage are low now, so we could get 5.5% rate right now).

One option would be to keep paying off the education loans, until we find the house we like, and then just take out a large mortgage and cover the education loans in one shot. This way, we will only have one large relatively low-interest debt. Has anyone done this? Any advice and suggestions would be appreciated.
posted by esolo to Work & Money (20 answers total) 6 users marked this as a favorite
... and then just take out a large mortgage and cover the education loans in one shot.

I'm not sure you can do this. The bank is loaning you money based on the value of your home. If you are approved for a half million dollar mortgage, the bank will only give you that much if the house you are buying is half a million dollars.

Are you sure you can get 5.5% with no money down whatsoever?

Anyway, I would pay off your loans as aggressively as you can, and buy as many RRSPs as you can, as the tax breaks make it worthwhile. You can use RRSP savings to pay for your down payment. That's what I did.
posted by chunking express at 12:31 PM on June 11, 2007

Best answer: How much (percentage-wise) of your monthly gross pay are you able to set aside for these goals? How much (percentage-wise) of your monthly gross pay is taken up by student loan payments? How much are you already paying for rent? What are home prices like where you live? From your post, it sounds like you guys aren't exactly bringing in hundreds of thousands of dollars, which also makes a difference (20% of 40K is way different than 20% of 150K obviously).

Without knowing the answer to these, it's a little hard to advise.

First off, do you have an emergency fund? Fund that first and then figure out the rest. Don't try to cover everything in one shot if it means taking on more debt than you can afford (particularly because you'll probably also pay for mortgage insurance if you go with no down payment, don't forget about that). Figure out how much you can throw at your financial goals, and how much you'll need to attain the goals you want, and then you can reasonably figure out the best plan of action. If you only have an extra $100 a month, that might generate different advice than if you had an extra $500 or $2000/month.

If I were you, I would put the majority of your money towards the loans, then make the house second priority and retirement third, but put money towards all three each month. Generally, I'm a fan of heavy retirement funding, but you're pretty young and at least it's on your radar as a financial goal.

Please don't get yourself into financial trouble because you want a house. If you can't afford a house, wait and keep saving your money.
posted by ml98tu at 12:50 PM on June 11, 2007

Response by poster: for ml98tu:

Thank you for your detailed response! I am 23 and my partner is 26. He is making 55K and I am making approx. 20-25K.

It's quite confusing with monthly payments, because we both have active education lines of credit. This means that we live off them (as chequing accounts that are in large negative), and all our paycheques go into the lines of credit, and all of our expenses come out of the lines of credit.

I am definitely aware that we will have to pay insurance if the downpayment is less than 25%, and we are fine with that. Paying the house insurance is better than paying rent every month, since that money is definitely going nowhere... I plan to cancel the insurance as soon as the home equity is over 25% (or whatever amount is required).
posted by esolo at 1:01 PM on June 11, 2007

The old rule of thumb was that your debt should not equal more than 25% of your income (can't remember if it was net or gross). So if your student loans are up there, pay them off first and what money you can into a down payment fund, then let your house build some equity.

Also, the rainy day fund is very good advice. Enough to cover 3-6 months basic needs.
posted by nax at 1:02 PM on June 11, 2007

Just don't forget the retirement savings completely. The one thing you have going for you right now is time, and if you save even a little bit now that can really add up over 40 or so years. If your employer offers matching contributions, definitely put enough into your IRA or 401k to maximize that money. If they don't offer a match, try to set aside 3-5% of each paycheck into a retirement account.
posted by arco at 1:18 PM on June 11, 2007

chunking express is right. You can't get a mortgage for more than the value of the house you are purchasing, so you can't pay off your student loans with a mortgage when purchasing a house.

You can get a no-down-payment mortgage if you have good credit, but you pay a premium for mortgage insurance. Currently, that premium is 3.1% of the total loan amount. So if you bought a $300K house, you'll pay an extra $9300 for the insurance. Contrast this with a situation were you put down 20% of the value of the home and pay only $2400 for insurance.

What you need to do is make a goal of when you'd like to buy a house and then do the math to find out if you are better off earning 4% in a savings account on a down payment to save the cost of mortgage insurance or paying down your student loans. Another factor, as chunking points out, is that you can put money into your RRSPs and then remove it to make a down payment on a home. Then you pay less in taxes, save on the mortgage insurance, but lose on the student loans. I suspect you'll do better with the RRSP/down payment route, but you need to run through the numbers.

Is your loan at all to do with the federal or provincial government? If it is, you can claim the interest you pay as a tax deduction, which would be another point for delaying paying the loan off.
posted by ssg at 1:18 PM on June 11, 2007

Recent reports in Canada suggest the housing market is due for a correction. (See last week's Globe and Mail.) You may want to wait to see what happens. However, interest rates are due to rise 5.5%.

Has a broker told you that you would definitely qualify for 5.5% with no money down? My mortgage broker has told us fixed rates are going to be 6.1% this month, and we have excellent profiles and are not first time owners seeking a high ratio mortgage.

Talk to a broker -- services are free. Don't jump at an ING mortgage, as you would not believe how horrible the service is or the other tricks they play. We left ING a few months ago and a broker had no trouble getting other banks to give us more favourable terms. Plus the broker does all the paperwork -- and, again, it's free. Note that the amount upon which they base your salary is a two-year average of income, not this year's income. So you may qualify for less than you think, especially since you have debt outstanding. Find out before you place an offer.

You may be better to make sure you have 6 months of expenses saved in an emergency fund (enough to cover future mortgage payments). Have you both been working long enough to qualify for EI? You might be able to make the fund a bit smaller, if that is the case.

Interest on student loans is tax deductible. I imagine your tax brackets are 16% - 40%, depending on your deductions. So you are each paying 4.8% to 6.72% net interest on those loans. This isn't much different from a mortgage rate, although I'm guessing your student loans aren't at a fixed rate, since that would be prime plus 5%, which should probably be high.

If you buy a home, you will need cash for closing costs, not a loan. You will also need to cover some expenses you probably haven't thought of and you may need some furniture, paint, etc. Make sure you have money set aside.

Don't just pay off your loans. Get emergency funds in place and save for a downpayment, along with closing costs and move-in costs. Note that you should save some of that downpayment through an RRSP (liquid) as you can pull out $20k each through the Homebuyer's Program. Thus, you get a tax credit on what you save.

I am not a lawyer, realtor, mortgage broker or expert.
posted by acoutu at 1:20 PM on June 11, 2007 [1 favorite]

Does the education line of credit basically mean that whatever is "leftover" pays off the loans?

Personally, I think it's okay to have an investment/savings account with a lower interest rate than that of one of your debts. My ING savings accounts pay less than the interest rates on some of my debts, but it's worth it personally for me to know there is a fund for XYZ (home, emergency, vacation, etc). Some folks (Dave Ramsey followers in particular) will tell you to throw all your money at the debt (after establishing a small emergency fund), and that's fine too.

The idea of a zero-down mortgage really scares me. And there are a LOT of costs besides the mortgage itself. ssg and acoutu make excellent points. If it were me, I would wait a little longer, and pay off the loans either as planned or a little ahead, but not so aggressively that you can't save for the other goals. At the same time, funnel money into home and retirement savings accounts. Good luck!
posted by ml98tu at 1:46 PM on June 11, 2007

Ahem, I meant to write that rates are due to rise 0.5%, not 5.5%. Although I suppose 1982 could happen again.
posted by acoutu at 2:06 PM on June 11, 2007

You are paying higher interest on your student loans than you would on a mortgage. QED.
posted by rhizome at 2:06 PM on June 11, 2007

After they write off interest, that may not be so, Rhizome.
posted by acoutu at 2:45 PM on June 11, 2007

You and your partner are not married (Fornicators < - just kiddin). find out what the laws are joint ownership of property. discuss what's fair who pays what, and who owns what, and what will happen if you split. useful even if you are married. br>
Decide what your goals are. If you are anxious to live in your own home, or want financial security, etc. Look at rents in your area vs. home ownership costs. Visit a mortgage broker and find out what you qualify for. Then ask yourselves the same questions.
posted by theora55 at 3:25 PM on June 11, 2007

Good question! We're trying to figure the same thing out these days.

We just bought a condo, and here's a little insight into those extra costs everyone's mentioning:
Closing and lawyer fees: $4000
Painting, furniture, random stuff: at least $1000 right off the bat, and we did everything the cheap way
The fridge broke last week: $600
Taxes: Not sure, the boy takes care of that bill -- several hundred
Had to replace the bathroom sink: $250

It just keeps going. My chequebook longs for the days of calling the landlord when things break!

What I've done is to follow the advice to pay myself first: 10% of each paycheque goes into retirement savings. Then I sat down with Excel and figured out how high my monthly student loan payments have to be to pay that off in five years. It's interesting to get it all set up and then say, "Hmm... what if I throw in an extra $500 this month... Wow, that saves me another $200 in interest and 3 months of payments!" Actually seeing how that works out has motivated me to throw more money at it.

I've also gotten a lot of advice to set firm goals and work towards them month by month. It's hard to save money for travel or renovations if you're not sure how much it will cost, and you just throw in money when you can. That leaves me with money that isn't "for" anything, and then we just spend it. But if I know a trip to Paris will cost us $X and I have to make a monthly payment of $Y to save up in time, then that makes it a lot more possible.
posted by heatherann at 4:28 PM on June 11, 2007 [1 favorite]

The interest rate on these is about 8% (it’s a private bank loan).

From a previous question:
The Government of Canada provides an Income Tax credit for the interest paid on government sponsored student loans.
So, unless you mean that this was a government sponsored loan facilitated by a bank under the old system (ended c1999), this loan is probably not tax deductible.

Pay it off :P
posted by Chuckles at 5:48 PM on June 11, 2007

I should add.. There are good reasons to keep government sponsored student loans around (pay them off slowly), even if the tax deduction isn't enough to make the interest rate attractive. In particular:
  • If you go back to school, interest charges stop
  • If you have a disruption in your income, you can go on interest relief

posted by Chuckles at 5:53 PM on June 11, 2007

"Paying the house insurance is better than paying rent every month, since that money is definitely going nowhere..."

There's plenty of money that goes "nowhere" with a house. Mortgage interest, for starters, doesn't go toward paying your equity. Look at a loan amortization table and see how much interest you pay for a 30 year mortgage.

There's also things like property taxes, fixing things when they break and closing costs, none of which add equity to your house (and adding a deck seems to be the only upgrade that adds more equity than it costs).

The flip side is that there are tax write-offs to some of the costs listed above, an accountant can help you work out how much money you would really be throwing away after taxes.

Also, there are serious psychological considerations to consider - most people consider home ownership to be a tremendous accomplishment, and it's hard to put a dollar amount on it. That said, don't feel bad that you're wasting money on rent right now, there's plenty of other ways to rent it.
posted by revgeorge at 8:04 PM on June 11, 2007

We were in a similar situation. We paid the student loans down aggressively since it was our highest interest debt. Savings only enough to get a down payment on the house. No RRSPs. On second mortgage (5 yrs. after house purchase), we consolidated the remainder of the student loan into the mortgage because it was a lower interest rate. We are paying the mortgage down steeply now on a variable rate mortgage which allows the variable part to go onto the principal. We're going to worry about kids tuition and RRSPs once we're more debt free. We keep a Visa line of credit for emergencies. Interest rates are only going to go up. Pay now will save later. YMMV.
posted by kch at 8:07 PM on June 11, 2007

Response by poster: 6 months emergency fund seems like quite a bit of money to keep liquid... Is there anything wrong with using a low interest line of credit as an emergency fund? Isn't it better to invest that money into long-term mutual funds so they can at least beat the market, as compared to keeping them in ING, in case something happens?
posted by esolo at 8:30 PM on June 11, 2007

Best answer: At 6.1% fixed rate with $20k down, they are looking at $1350 a month on a 25-year mortgage. Add $300 for strata fees, $125 for property tax (after grant), and $100 average for heat/hydro. Assume $800 a month between them for student loans. $400 for groceries. $100 for phone/Internet. $200 for transit passes. $75 for life insurance to cover the mortgage. That's $3375 a month and we haven't touched any other necessities or basics. If the guy loses his job, they can't cover their costs on esolo's income. If esolo is out of work, a huge amount of the boyfriend's income goes to cover both. And EI only pays out about $1400 a month. They would have no wiggle room -- and I have no idea whether their student loans are actually higher or they have other payments. Six months is not a long time to be out of work, especially if the economy changes. In 2001, my husband and I both found ourselves out of work -- and we'd thought we were part of the fabulous digerati, the indispensible class of knowledge workers.

Mutual funds aren't a great place to put your money if you're young with limited resources. If the market declines (as some are saying it may), you could lose 20%. Then you won't have much of an emergency fund.

A line of credit might be okay, but these people haven't see any upside in appreciation and they don't have the funds to pay down the mortgage. They could find themselves in a situation where the market tanks and they owe more than their home is worth. The bank may not like that.
posted by acoutu at 10:39 PM on June 11, 2007 [1 favorite]

You're looking at it as an either/or and having a sound financial life is not an either/or situation. Continuing to look at interest and return rates (which, in several of your calculations, are best case scenarios), rather than the practical applications behind the recommendations, is really not going to help you move forward.

For the mutual fund, you're assuming that you can do better than 4% when you may end up losing money. In fact, the whole idea of a long-term mutual fund is counter-intuitive to that of an emergency fund. You need to be able to pull the money out in an emergency.

Yes, a line of credit might do the trick, but you're already talking about extending yourself into a lot of debt, do you really want to leave your emergencies to that too? Then you're going to be paying interest on your emergency borrowings, when you could otherwise be earning interest on your emergency savings if it was held in an account.

It is completely okay to have money in an emergency fund that is not high-performing. An emergency fund is not an investment, it's an emergency fund. If you can park it and end up making 4% through a high-yield savings account, well that's just gravy.

P.S. I see you've marked best answer (and hey, thanks!) however I think acoutu is best answer on this one.
posted by ml98tu at 6:46 AM on June 12, 2007

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