Is it better to save for a house or pay off debt?

John W. Schoen Senior producer • Profile • E-mail

Managing debt when you’re just starting out is never easy, but it’s especially tough these days for first-time home buyers. For example, if you’re saving for a house, is it better to pay off student loans first or put everything toward a down payment?

My fiancé and I are recent graduates. We are saving for a down payment on a house and have $15,000 so far. We have around $14,000 in student loans. Would it be wiser to pay off our student loans now, or use our savings for a larger down payment and carry the student loan debt along with a mortgage?
— Katherine R., Montclair, N.J.

You’ve got two different decisions here, so you may be better off making them one at a time.

The first is whether to pay off your student loans. That depends a lot on the interest rate you’re paying: If you’re stuck with a high rate, you may be able to save faster by getting rid of that expense. On the other hand, if the rate on your loan is lower than what you’ll pay for a mortgage, that student loan is “cheaper” than a mortgage — so you may as well leave it alone. In general, when deciding which order to pay debts off go with the costliest first.

The other question is whether or not to buy a house — and how much to save before you do so. The answer to that one involves a different set of considerations. To make your decision, you’ll need to know 1) how big a down payment a lender will require for the loan you expect you’ll need 2) what kind of interest rate you’ll qualify for and 3) how big your monthly payments will be for the price range you’re considering.

Step No. 1 may be the biggest hurdle: These days lenders are demanding much bigger down payments than the no-money-down, go-go days of the housing boom. They may also want to see a bigger down payment to make up for any student loans outstanding. Or you may be able to consolidate your student loans with your mortgage. You won’t know until you sit down with a lender.

So start by shopping for a loan — before you start shopping for a house. This may seem like putting the cart before the horse, but you won’t know how much house you can afford until you find out how much mortgage you can handle. If your credit history is weak, you’ll pay a higher rate — if you can get a loan at all. If so, you may want to wait awhile to strengthen your credit, save a little more, and try again.

You’ll also want to write up a detailed budget to figure out how much of your monthly income you can realistically devote to mortgage payments. (Don’t forget to factor in the tax savings from deducting your mortgage interest.)

Only you can decide what’s affordable. During the craziness of the housing bubble, brokers were talking people into spending more than half of their paycheck. That’s just not sustainable — a third is probably about as high as you should go. But every situation is different. If you expect your salary to go up, you may want to stretch a little bit at first. If you’re worried about losing your job, you may want to play it safer.

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