Help a Reader: Debt versus House

Here's an email I recently received from a reader:

Here is my personal situation:

25 years old, with bring home pay of $2775.17 a month ($4038.64 gross pay).

To debt:

• $520.23 a month auto loan, $6,000 left on loan, 6% interest
• $131 a month to student loan #1, $11,300 left on loan, 10% interest
• $65 a month to student loan #2, $5,000 left on loan, 8% interest
• Total: $716.23

No credit card debt.

5% of pretax salary going to 401K, with 4% match, equaling $363.48 a month.  Current balance $5,600.

$500 in basic savings account, my only semblance of an emergency fund (not contributing to this fund)

~$700 in mutual fund account, (not contributing to this fund)

I'm in the middle of 'stage one' of a debt snowball.  I consolidated my car loan to a lower interest rate and upped my car payment by ~25%.  This will be paid off Sept 2009.

In one year I am going to be at a crossroads.  Continue my debt snowball to tackle my student loans or save for/buy a house?  Because of the current market I would like to buy a condo/house in the next few years.  But if I continue my debt repayment aggressively I will not be able to START saving for 2+ years.  I don't want to foolishly miss out on an opportunity like the current market.

I feel like I'm on track for long-term/retirement savings (besides starting a Roth IRA).  I feel like I am on track for short term savings, by putting away monthly for periodic bills like car insurance, etc, and sticking to my budget.  But I am seriously lacking in the middle.

I need an emergency fund and/or a "next big thing" fund. 

Should I change my current plan immediately and start saving for a house, build an emergency fund?  Should I quit/adjust my debt snowball once my car is paid off next September and start saving for a house then?  Should I forget my house saving until my debt is fully paid off in 2+ years?  Any critiques on my current plan?  Any further information needed?

More info:

• Credit score: 663
• Looking to buy a condo/house around $130,000

Although  I have a somewhat high 'entertainment' budget, my budget in all other areas is pretty tight.... although it’s up for review:

• Rent: $789
• Utilities: $50 (average)
• Cable/Internet: $96
• Athletic Club: $55
• Cell phone: $60
• Prescription: $20
• Car payment: $520
• Loan #1: $131
• Loan #2: $65
• Periodic Bills Account: $150
• Gas: $150
• Groceries/Dining: $150

So, what would you tell her to do?

Comments

[Mr. ToughMoneyLove]

Right now residential real estate is not a good investment - short or long term - and condos are the worst. Better off to rent, pay down debt, and hope she remains employed in today's economy. If something bad does happen, at least she won't have a house payment hanging over her head. Also, the credit score needs work to get the best mortgage rates.

[Anne]

I would avoid getting in more debt by buying a house until you are debt-free everywhere else. If you do not have a fully-stocked emergency fund, you have no business buying a house. As long as you are renting, you have the option to get out if something horrible happens. As soon as you own a home, you're stuck with it, regardless of your job status, personal emergencies, etc. You have relatively little debt, and should focus on paying that off so that when you DO own a home you're not saddled with even MORE debt and years left to pay on the original. Only in the U.S. are 25-year-olds made to feel that they should be purchasing a home... You have plenty of time for that. And while the market may seem perfect right now, it's only perfect if you can afford it. That's my 2 cents. :)

[Brian]

Pay down debt, save more, max out retirement savings (Open your roth TODAY) before trying to buy a house. The housing market now is tempting, but never forget to pay your (future) self first.

[Rod Ferguson]

A house for around $130k will translate to roughly $1200-1400 per month in total mortgage-related expenses; about $750-800 in the mortgage itself, roughly $90 in PMI, $50-$75 in homeowners insurance, and (depending on what property taxes are) maybe a around $200-$400 in property taxes. Insurance and taxes are the big "ifs" there - could be lower, but could be much higer... and I'm assuming a 30-year note. A house would just knock him over the edge for his monthly income, leaving nothing for when the water heater bursts or the roof needs replacing or even just wanting a new color of paint in the living room - and he'd have to trim his entertainment budget to get there.

My advice - either lower your buying expectations, raise your income, or keep renting for a few more years. Even saving up that 20% will only knock off about $150 per month (PMI + lower loan amount) and will cost you $26k to do it.

[LotharBot]

Get your debt dealt with first. Houses aren't going anywhere.

Historically, house prices and incomes for a given city will sit at a given ratio. Right now, only a few of the cheapest foreclosures are actually the sort of deals you should look to "take advantage of" based on historical norms. The only reason it seems like there are so many "great" deals out there right now is that we're coming down off of such a ridiculously large bubble, and some houses are selling for significantly less than their peak value.

When house prices settle down to normal, there will be plenty of deals just as good as the ones you can get right now, and probably better. The interest rates will no doubt go up, but housing costs will go down. And if you've got your debt paid off and a decent emergency fund, you can actually afford to buy without risk of having to take out very expensive loans for emergencies.

[Jo]

Definitely pay off your debt and I would start contributing to the emergency fund right away. $500 is will not cover you if something big happens...should atleast $1000 while you are reducing debt, then build it up to cover 3-6 months of expenses, so about $8,000-$16,000.

I would snowball the car and the smaller student loan. Followed by the larger one while saving up.

You could start putting a small amount towards saving for a house right now (put interest to work) but don't buy until you have a good size downpayment and the job/finance/housing market are good.

[Jim]

In general I'd say you should continue to pay off the debt. Pay off the bills first and give yourself some more room in your budget. Then save up a good 20% downpayment.

There is really no rush to be in a house. The housing market isn't necessarily at the bottom yet so you may not be losing out on an opportunity.

Do we know what state the writer is in? The real estate market has varied a lot state to state. I'd be more wary of some markets and more confident in others.

Rob, re: "$50-$75 in homeowners insurance" Thats pretty high for where I live. Insurance rates will vary quite a bit depending on where you live. I'm paying $200-300 range for homes that are worth $200-250k range.

Jim

[Jim]

I meant that I'm paying $200-300 per year.

The $50-$75 a month equates to $600-900 a year.

Jim

[Rod Ferguson]

Jim - Depends on whether or not you include belongings in your insurance. TV, Stereo, PC, laptop, etc, can add up. Although, cutting the $50-75 down to even $25 isn't much of a savings to the total.

[Rick]

I agree wiht the other commenters, but from a slightly different perspective. It's a simple numbers game. Once your car is paid off, you have the option of paying off your student loans at ~8-10% return, or investing in a house. For the house to be a better investment, the house must appreciate by at least 8% a year, maybe slightly different based on tax consequences. I simply don't see that happening in this market. The housing market may or may not have hit a bottom (I don't think it has), but it is very unlikely that the house will appreciate by more than 8%. Thus, you should rent for awhile.

You have the added problem of having a fairly low credit score. If you wait 3 years to build up that credit score, you can: (1) wait for the housing market to bottom, (2) build up your credit score, (3) maybe save some for a down payment.

All these point to, wait a few years.

[Bad_Brad]

Until you have two months of expenses socked away in an emergency account, I would not do anything else. You must have this. If your job suddenly disappears or you have sudden medical / car maintenance / other unforeseen expenses, you need to have that money available.

After that, I would echo what others have said. At this point, you're going to put yourself in a situation where your minimum debt service payments are too much of your take home income. I would recommend at least paying off the car first before buying the house. This also gives you time to build your two month emergency fund and also improve your credit score, which will qualify you for better mortgage rates.

[Jim]

Rod, our policy covers over $100k of personal property. The cost of home insurance varies a lot from location to location. The differences in the rates depend mostly on the likelihood of natural disasters.

For 2005, average homeowner policy prices vary from a low of $477 in Utah to a high of $1372 in Texas. Ref:
http://www.iii.org/media/facts/statsbyissue/homeowners/

I live in one of the cheapest states.

So insurance on a $130k home might cost $900 a year or more in one state but could be just $200 in another state.

Jim

[Jim]

Rod,

I don't mean to disagree with your point though.

You are very right that the costs of a home are much more than the basic mortgage payment. Taxes, insurnace, PMI, higher utilities, maintenance, etc. all add up.

Jim

[Margo]

As soon as the car loan is done, put the next 3 months' worth of those payments into your emergency savings, which will get you up to $2000.

Then, take that $500/month payment and:
1) set up a regular "self insurance" payment to this emergency fund, $50/paycheck ongoing.
2) add $50/paycheck to start a house fund - just enough to get in the habit. Psychological benefit of making progress.
3) Add remaining $300 to your student loan payments.

Then, whenever you get a bonus at work:
20% for something fun
30% to your house fund
50% to your student loans

Regarding your budget --

Your rent is pretty high, for an area in which you could realistically buy a condo for $130K. Does this involve moving from a more central/urban location to the suburbs? Be sure you factor in the new reality of $4 gas when looking at real estate.

Take a hard look at your cable/internet bill. If you're on RoadRunner, they have a "lite" service which is about $20 cheaper. In my area, it's $35 vs. $45 or so. I notice no impact to my web surfing speeds, and I can watch online TV shows with no problems. Unless you're downloading LOTS of music & movies, you shouldn't have a problem switching to the Lite service. Consider turning off your cable during the summer when all the stations are showing re-runs. You could save $240 with no noticeable impact on Internet and $150 if you quit cable for the summer. That would give you the beginnings of an "opportunity fund"

[uFirst]

where do you live? because that can be the deciding factor in choosing which option would be best for you in the long term.
-jake

[kitty]

I agree with waiting with buying a house.

What I don't quite understand why she is putting extra 25% to her car 6% loan and not a much higher interest student loans? Her car loan is at 6%, her student loans are at 10% and at 8%. Yes, I heard all about Dave Ramsey and such, but we aren't talking about some math-challenged compulsive shopper who needs an emotional feedback "oh, I paid one loan this is progress, never mind that I lost money in the process" and who without such emotional feedback would slip into getting back into debt. This is somebody who has no credit card debt. So supposedly she is smart enough to know that her 10% debt grows faster than her 6% debt. 10% is huge. This "emotional" thing may work for some people with huge CC debt, but this lady isn't one of them. It is really just one pool of money - debt and savings together, one part positive and one part negative. The goal should be to make the total larger. How would you increase the total - by doing what gives you the highest return. Once you look at the total, you don't need the self-deceit of having one debt less. Because you see how your total gets larger.

Keep in mind, also that student loans cannot be discharged in bankruptcy - no she isn't planning to do it, but emergencies happen. And I don't mean your regular-life mini-emergency for which your regular emergency fund is enough, I mean real emergency like expensive illness. Young and healthy people get sick too, and sometimes insurance doesn't cover everything. If, heaven forbid, something like this happens, car loan can be discharged, but not student loans. They can go after her, they can garnish her wages.

So please explain to me the logic of going after the car loan first?

[Kurt]

Go buy Dave Ramseys book. total money makeover and it will give you a step by step path to what you want to do. follow it as I did and you will feel freedom like no other.

[mrm]

I agree with Kurt. If you have debt you should be paying off, you don't need to go buy a house or start saving for a house because it's just going to stretch you out that much longer on your debt and keep you at a less secure level financially for a longer period of time. Once you have that debt paid off, then you will have a ton of cash you can save for a house. Plus, the issue of whether or not "real estate is a good investment now" is a moot point. The house you live in will never be an investment. It's just a roof and walls for you to chill out in until it's time to go to work yet again the next morning. It doesn't matter when you buy your house in relation to where the market is because you aren't going to do anything dumb like sell it too soon after you buy it and lose money. If you're looking for a potentially nice house for a steal, instead of taking advantage of down market prices, you should be taking advantage of foreclosures themselves. That's where your benefit will be unless you build the house yourself, which is what I'd like to do for our next house.

Then again maybe my point of view doesn't make sense to others.

[Andy]

There have been plenty of comments towards your actual question but you also asked for budget critiques so here's mine.

Consider ditching the gym membership and a good chunk of the gas by biking to work (at least until it starts snowing). Not sure where you live, but here in Indy, you can put your bike on the local bus to increase the practical range. My philosophy is that if I live too far away to bike to work, then I live too far away to drive with gas prices the way they are.

[jim]

1. cut your losses and sell the car ($520 a month?!), find something reliable in the 3k-4k range

2. put the $520 towards the 10% loan first, then 8%

3. fund 401k up to 4% match, then fund ROTH IRA

4. save for 20% downpayment on house/condo

[Rich K]

I wonder where the other 20% of the monthly take home is going?
Also the accelerated car payment is 20% of take home. I hope you plan on keeping the car a long time. $22,300 in total debt. Your monthly expenses listed excluding debt payment are $1520. YOur gas is equal to your grocery/dining outlay?. Both of those are going up. So will your rent. Plan for that. If you use $1000 of the 1250 monthly difference you can pay all debts in approx 2 years. If you focus on paying off all the debt as soon as possible, the total interest paid will be minimized. If you drag it out, you are wasting more money. What if you get sick or have an accident that puts you out of work for 2-3 months? What if you lose your job? Both of these can happen through no fault of your own. A new job may not pay as well at least to start. As stated before, the finance of buying a house is not just about the mortgage, taxes, and insurance. There are the transaction, moving, furnishing, and maintenance costs also. And the numbers are bigger when stuff happens. Any home repair can easily be $250 - 500 even in a condo. What about association fees? It is never a good time to buy if you can't afford it. Get Dave Ramsey's Total Money Makeover. Many say the plan is too simple but that is why it works. It is not just about the numbers, because the numbers the whizzes tout don't take into account the risks of everyday life. Stuff happens. I would rather have my net worth grow a little slower, have less stress, and more fun. Pay off all the debts, have a decent emergency fund and save for a 20% down payment and plan for a 15 year mortgage. In the meantime enjoy your 20's, focus on your career and establish your relationships. If you decide to get married, you will bring more flexibility and less baggage into the relationship. You will have more options to move and establish a home. The fact that you are reading this blog and have a handle on your budget puts you way ahead of most of your peers.

[Jake]

Pay down your debt.

Every dollar you pay your student loan gets a 10% rate of return, just by avoiding that interest. It is historically speaking very unlikely that the Real Estate market will approximate that rate of return.

In addition, going into more (mortgage) debt when you're already in debt vastly increases your personal financial risk. What happens if your income decreases for some reason? If you have large unexpected expenses (car breaks down? medical?).

The smart move is to pay down your debt first, as everybody will tell you. The only question is whether you have the guts and patience to do the smart thing.

[Jaime]

Marry me?

[LC]

I think your spending is pretty reasonable. The only areas I see to cut back are the gym membership and the cable, unless there is a cheaper place to live or if you can get a roommate. Adding up your spending, it seems as though there is about $539 extra you have each month that you didn’t say where it was going. I would first build up your emergency fund to ~$1000. Then I would put the extra toward your car loan and you can probably pay it off before Sept 09. Then, you will have $1059 extra per month, which I would put toward your $11k student loan until it’s down to about $5000.

At that point, just pay the minimums on your student loans while you start saving for a house. DO NOT buy a house with less than 20% down, which means that you need $26,000 for the down payment. In addition, you will probably need close to $5000 for closing costs, and you also want to have a substantial emergency fund (~$10k) before purchasing a house. So this means you shouldn’t buy a house until you have close to $40,000 in cash. On a $130k house, your payment will be around $1000 including insurance and taxes (give or take), and your utilities will be more like $100-$200/mo, so be sure that you have room in your budget for that. I would expect that saving up that much money would take you almost as long as it does to eliminate your debts paying the minimums.

Starting a Roth is a good idea, but if you do, I would only put maybe $2000/yr in at most until you have your debts paid off and house saved up for.

[tom]

According to your budget, you have roughly $550 left over for entertainment and other so here is what to do:

1) Consolidate your student loans. You can get 4.75% to 6.125% on your consolidation loan. Just pay the monthly payment, it will be much lower than now.

2) Build up an emergency fund. 3 months or more... whatever you feel most comfortable with.

3) Open a Roth IRA and start contributing. It's easy to do at Vanguard.

4) Set a budget for entertainment. It'll suck to do, but necessary.

5) Set a goal for when you want to buy a place. 20% Down payment would be ideal, but have at least 10%. Deposit as much as you can into this.

6) Snowball, snowflake, whatever the rest to your auto loan.

Bottom line... Invest a Roth, contribute to your E-Fund, start saving for a down payment, then use the rest each month to pay off your auto loan.

[Rachel]

Wow everyone, OP here. Thanks for all the advice!

To answer the questions brought up...

Kitty: I had a horrible 15% interest on my original car loan. I bought it right before my 'financial epiphany' occured... when I was clueless. So the 6% I am paying now is my consolidated interest rate, and I am locked into the $520/month payment.

And I live in Wisconsin.

[Rod Ferguson]

Rachel - whereabouts in Wisconsin? If you are close to a border, you might be able to adjust your expectations by living across the state line (in Illinois, for example, property taxes are lower. In Michigan, housing is cheaper. In Minnesota and Iowa, both are cheaper.)

[Kevin]

Get rid of those debts, they are at pretty high rates. The housing market likely won't jump the way it has in the recent past, so you're not going to miss out on any huge gains.

Believe me, it's amazing how much money you'll have each month when you don't have debt to worry about. Plus, by then your life may have changed (marriage, baby?) and you might not want a condo anymore. One of my mistakes in my early career was buying a house too soon and not paying off debt as fast as I could have.

[Rachel]

I am in Madison. Not close enough to the border to consider another state.

Again, this is all SO good to hear... I had myself almost completely convinced that the 'house' dreams should wait, and I was all pumped up for my debt snowballing, then I recently had ONE person give me the opposite advice, and I was doubting myself again.

Kevin: You are so right, to bring up that I might make some life changing decisions in the next couple years, such as marriage, that might make already owning a home less desirable.

Last week I also put out an ad for a roommate, as well, so now I might have an additional $350 a month to add to the mix! I should definitely use this money to buy tons of dvds and useless gadgets, right?

[Jim]

Madison, WI has not been hit very badly by the real estate slump. Its only off a few % from its 2007 peak and 2008 prices are above 2005-2006 numbers.

Your market is more stable than some places. And the prices haven't dropped all that much in Madison so its not as if there are amazing bargains to be had there.

I'd go ahead and keep paying down the debt first and then save for a good 10-20% downpayment after that.

Jim

[David]

I am in a similar situation... Student Loan debt vs House Down payment. I saved an emergency fund (3 months pay) and now have been putting almost every last penny towards the student loans. I still save a few bucks for that encouragement of some day owning, but when I do own I want my mortgage to be the only thing I have.

Kevin made an excellent point about changing circumstances. Many times it does not pay to buy unless you plan on staying there for 5-7 years or more. Until that point you are paying a lot of money in interest and very little towards the actual principle of the loan.

I just paid my car off (~two years early) and as you pay off each loan you will find how rewarding it is to have one less payment. It is a great motivation to keep paying everything off.

[Anitra]

"I need an emergency fund and/or a "next big thing" fund. "

You said it! You should have several thousand dollars in your emergency fund before you consider buying a house.

We had student loans (but no other debt) when we bought our house. We made sure that on top of our down-payment, we had about $8,000 in savings - good thing, too, because our "affordable" house has needed several major repairs in the year we've lived there.

Also, I wouldn't even THINK about buying property until you are sure you can live there for at least 5 years. You're young and single; in five years you could be married and have children - so unless you're buying a house that would work for a young family, you stand a good chance of taking a loss on your "investment".

[Kenny]

Emergency Fund......That is for people with issues. You should rely on Emergency Funds from your family.

1. If you have a $520 in car payment, I bet you love your car, even though it is after a consolidation. So, keep that car, and continue to make that payment.

2. Save MORE. Your BEST OPTION. Cut back on the cell phone. Cut back on Periodic Bills. Cut back on entertainment. Buy groceries ONLY on sale. Have more get-togethers INSIDE the home. Cut back on liquor esp. the watered-down-beer.

3. Pay off the HIGHEST interest rate loans first from the savings every month.

4. Start looking for a Home, and NOT a condo. Condos are hard to sell. And, why am I talking about selling. Since you seem to be a SMART SAAVY FINANCIAL GUY, who has asked a great question, and should really be in a HOUSE. If so, I will assume you will want a house. Then just go directly for a fixer-upper-house.

5. Make sure you get a decent downpayment ready before you jump into a house.

6. Plan to close on the house in Apr or May'2009. Until then, keep searching on Realtor.com, hire 3 real estate agents and have them send you listing via email. In the middle of winter go and look at homes (worst time for sellers, best time for buyers).

7. Finally, come back and THANK all of the people that helped here with great advice.

Good luck my friend......Been there - Done that - Over it now by being very frugal/thrifty/wise-shopper

Kenny

[K]

I thought Kenny was joking at first but I think that his advice was serious, although most of it was off-base. You do need an emergency fund and should not need to rely on your family. First of all it's irresponsible, and secondly, what if they are in trouble too? $520 is a pretty large car payment, and it may make sense to sell it and buy something cheaper. If you do buy a house, only buy a fixer upper if you can get a great deal and if you have the energy and money to fix it up. Otherwise you'll be miserable. Do not plan on closing on a house until you have a 20% down payment and have found the right one for you. Setting a deadline is asking for trouble.

And lastly, this person is a women, not a SMART SAAVY FINANCIAL GUY, but I guess she should take that as a compliment. :)

[Meg]

1. Continue to pay the minimums on all your debt payments and contribute enough to the 401k to get the match. Continue to build your credit by paying all bills on time and making sure you have at least one credit card to diversify the type of debt on your credit report.

2. Build up your emergency fund to at LEAST 1 month of fixed expenses (rent + debt obligations + basic utilities + gas/food).

3. Start your debt snowball, putting as much money as possible to your student loans (pay the minimum on your car because the interest rate is lower).

4. Build up your savings to at least $10,000.

5. Buy a home and put down 5% - 10% only IF you're planning to stay in Madison for the foreseeable future. At your age flexibility can be worth more than homeownership. (Don't bother trying to save until you have 20%; most places don't require that of first time buyers, plus while you save home values will just keep rising.)

[Dave Farquhar]

I agree, pay the debt off first. In 2-3 years there will still be people trying to get out of bad interest-only or adjustable rate mortgages.

You might consider trying to trim that budget back a bit to pay the debt off sooner and save up a downpayment. A cheaper cell phone and switching to basic cable and the slowest Internet speed offered are the two obvious places to cut. Using plastic film on your windows in the wintertime can cut your utilities a bit, and if your landlord will let you install a programmable thermostat, that will help too. Pack your lunch if you don't already, bring your own coffee from home, stuff like that.

I squeezed my budget just as tightly as I possibly could, and my wife and I paid off our mortgage earlier this year. I'm 33, and when I was your age I didn't make what you're making.

All that said, you are in good shape overall. You're making a respectable salary, you're saving for retirement, and you're paying off your existing debt. When I was 25 I was accumulating new debt.

As for the house, save up 20% (you'll be surprised how quickly it piles up once the other bills are gone), then pay $1500 a month toward that mortgage so you get it paid off as quickly as possible. With reasonable annual raises and applying windfalls to the mortgage, it's entirely possible to own the house outright 7 years after you buy it.

And keep your emergency fund. Since buying my house, I've had to replace the dishwasher, hot water heater, furnace, and air conditioner. $1,000 a year is a workable budget for upkeep. The dishwasher cost a lot less than that, but an air conditioner or furnace will cost about $3,000. I could have put those purchases off if I'd spent $70 a year for an annual inspection/maintenance on those.

[mom]

I am her mom and very proud of her. I am also the ONE person who has advised her into looking into buying a home now.

I bas this on:
1. the depressed cost of real estate currently
2. the low interest rates available currently
3. the interest would be tax deductable
4. her $789 rent would be eliminated
5. I do not think the actual increase in cost incurred to her would be alot higher when looking at the above facts
6. if she waits and saves for a downpayment, that money could be eaten up in the increase in the cost of the homw anad increase in interest rates.

I have enjoyed reading the comments and see much wisdom displayed here also.

She will be successfull no matter which way she decides to go.