Student loans and mortgage debt are often considered to be “good debt,” as they are forms of debt you take on in order to purchase something that should increase your net worth. “Bad debt,” on the other hand, includes credit card debt, auto loans, and other consumer debt incurred to make purchases that depreciate in value.
Regardless of the classification, debt needs to be paid off at some point. And if you have a little extra money every month, you may ask yourself: Should I accelerate payments on my mortgage or student loans? And, if so, which should I aim to pay off first?
Determining Whether to Pay Off Student Loans or Mortgage Debt
While there is a great deal of debate as to whether student loans or mortgage debt should be paid off early, there is little debate about when not to do it. You should not make extra payments for either of these debts until you first do the following:
- Pay Off Consumer Debt. If you have a car loan, credit card balances, personal loans, or any other types of debt with higher interest rates and non tax-deductible interest, you should always pay off such debts before tackling an early mortgage or student loan payoff.
- Establish an Emergency Fund. An emergency fund containing three to six months of living expenses protects you from having to take on consumer debt to pay for an emergency, such as a home or car repair. It doesn’t make a lot of sense to send your extra money to repaying student loans or mortgage debt if it will leave you without the cash to handle an emergency.
- Fund Your 401k to Your Employer’s Match. If your employer matches your retirement contributions and you aren’t contributing at least the amount matched, you are essentially giving away free money.
If you are in good financial shape, have your other debts paid off, and are taking advantage of the 401k match, the question of whether to pay off your student loans or mortgage early becomes a bit more tricky.
Reasons to Pay Off Your Debts Early
There are plenty of arguments to be made for paying off your student loans and mortgage early. For example, when you pay off your mortgage or student loans, you enjoy the following benefits:
- No More Wasted Money on Interest. While you can take a tax deduction for mortgage and student loan interest (if your income falls below a certain threshold), the deduction does not completely cover interest costs. Money spent on interest is wasted, while money saved on interest provides a guaranteed return on your investment.
- More Financial Freedom. Without a mortgage payment or a student loan payment, you can do what you want with your money – including building wealth and saving for retirement.
- Less Risk. If you have debt payments, you must have income to cover them. If you are debt-free, a job loss, disability, or other temporary loss in income doesn’t put you at risk for losing your home or ruining your credit.
- Elimination of Non-Bankruptable Debt. While bankruptcy can resolve some debts as a last resort, student loans are not dischargeable in bankruptcy. You also can’t erase your mortgage debt in bankruptcy if you want to keep your house. Since you can’t wipe out mortgage or student loan debt, the only way to eliminate it is to pay it off.
Arguments Against Paying Off Your Debts Early
While the arguments for paying off your mortgage and student loans early can be pretty persuasive, there are also plenty of arguments against paying them as well. For example:
- Student Loans and Mortgages Are Low-Interest Debt. This is the biggest argument against pre-paying mortgages and student loans. With low student loan and mortgage interest rates and the ability to deduct interest, it is easy to find investments that pay more in interest than you pay on your debt, especially if you invest in tax-advantaged accounts, such as a Roth IRA.
- Pre-Payment Comes With Opportunity Costs. When you invest and earn a return on your investment, that money can be reinvested – and you can earn money on that investment as well. This is referred to as compound interest. Compound interest can make a big difference in your retirement and long-term savings, and the more you invest when you are young, the more your money will grow. For example, if you invest $100 per month from age 20 to age 40 and earn 8% compounded annually, you’d invest $24,000 and have almost a million dollars when you turn 65. If you waited and invested from age 30 to 50, investing the same amount of cash and getting the same return, you’d have only $205,875 when you turn 65 – or $750,000 less. This is because, in the latter example, your money has less time to grow between when you stop contributing and when you start withdrawing for retirement. Putting that extra $100 a month into retirement savings instead of student loan repayment makes a big difference.
- Loan Repayment Isn’t a Liquid Investment. Once you’ve paid off your mortgage or your student loans, it is usually very difficult to get your money back if you need it for any other reason, such as for an emergency or to cover income loss due to unemployment. You can’t reclaim the cash at all with student loans, and while you could sell your house, there would be closing costs and fees – and the home could sit on the market for months.
Determining Which to Pay Off First
If you’ve weighed the pros and cons and decided that early payoff is right for you, the next question becomes whether to pay off the mortgage first or the student loans. The answer to this question depends on a number of factors:
- Interest Rates of Your Debts. Many people want to pay off higher-interest debt first. This can be a good idea, but isn’t always the best idea. Be sure to consider all factors, especially the tax treatment of the debts. Mortgage interest is usually tax deductible for everyone, while the ability to deduct student loan interest phases out at higher incomes ($75,000 as of 2012). Student loan interest deductions are also capped at $2,500 per year. Compare the effective after-tax interest rates on your debt to determine which debt truly costs more.
- Amount Owed for Each Debt. Dave Ramsey’s debt repayment method suggests repaying smaller debts before larger ones in order to remain motivated with your debt payoff plan. If you owe much less on your student loans than your mortgage (or vice versa), then it might make sense to pay off the smaller debt first so you have only one remaining debt to focus on.
- Risks of Adjusting Rates. If you have an adjustable rate mortgage, there is a risk that the interest rate – and monthly payments – will go way up when interest rates rise. Paying off an adjustable rate mortgage or paying it down enough so that you can refinance if you need to can be a smart bet.
- Flexibility of Repayment. When you have student loans, you can usually put them into deferment or forbearance if necessary due to job loss, disability, or a return to school. While the interest continues to accrue in most cases, you don’t have to make payments for a while. You can also choose to tie your payments to your income or use a graduated repayment schedule in some cases. With so much flexibility, tax deductible interest, and low interest rates, it almost never makes sense to pay off student loans before other types of debt.
Ultimately, everyone needs to make the choice themselves about whether early mortgage payoff or early student loan payoff is right for them. For those who want to live a debt-free life, who are risk-averse, and who want a guaranteed return on their investment, early mortgage or student loan payoff may be the best answer. For more aggressive investors who are willing to carry the risk that goes along with a little debt, skipping the early payoff can be a viable option.
Have you accelerated your student loan or mortgage payments? Why or why not?
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