Reader Mailbag: Paying Off Student Loans vs. the Mortgage

Jackie writes in with the following question about student loans and the mortgage:

We’ve been using Dave Ramsey’s formula to pay off debts, not incur new debt, etc. We are down to 2 debts:  Student loans (consolidated) with a $151,000 balance @ 3.875%, and the home Mortgage, $165,000 balance @ 4.5%. We have 6 kids, so lots of household expenses (mostly groceries), but we can trim a little more fat.

We have $1,000 in savings for emergencies (just replenished after an unexpected 800 car repair). We pay cash or we don’t buy it.

Income is around $80,000 per year, with no great increases in the foreseeable future (government employee).

At this point, we’ve been throwing extra money at both of these debts and don’t seem to be getting anywhere. I was awarded a public-service award that will pay up to $10,000 per year on my student loan debt (payable quarterly) for up to 6 years. This year the award was $8,900. Of course the student loan company used the money to advance my due date and not pay towards principal, but I had it placed on principal eventually and continue to make my normal payments.

My gut tells me to focus on the student loan debt, especially because I have the award to help and pay the mortgage at its normal rate, but then I look at the interest rate being higher on the mortgage and think I should pay it off first.

I do use the student loan interest deduction on my taxes. Last year was the first year we had enough expenses to justify itemizing deductions, so I don’t think that will be something that will happen every year, we just had an extraordinary amount of medical expenses.

Thanks for any help you can provide us!

Thanks for writing, Jackie. It sounds like you have your hands full with six kids and significant student loan debt. However, it also sounds like you guys are making smart decisions with an ultimate goal of debt freedom. Congratulations on clearing all consumer debt – that’s a great first step!

In my mind, I would probably treat both of these debts in the same manner as I would a mortgage. In “Baby Step” language, that’s near then end of the process, around Step 6 – Paying Off the Mortgage.

My reasoning for this is that both debts will take some time to pay off, even with a healthy $80,000 household income. I’d hate to see you guys not make progress on the remaining baby steps over the next several years while focusing solely on student loans and the mortgage.

Now, as far as interest rates go, that wouldn’t necessarily be the determining factor in deciding which to pay off early when the time comes. As Chris at MyTotalMoneyMakeover.com writes,

A common misconception about paying off debt is that you need to go after the high-interest-rate bills first. The reason is because big rates mean more money is going out the door. The sooner you stem that, the more money you’ll save.

That’s the wrong way to gauge which bills should go first. You could spend months paying off a high-interest-rate loan and become disappointed when you still see an outstanding balance. You’ll subconsciously think that you’re not making progress, and you’ll stop paying extra. Then the balance grows back and frustrates you even more.

Getting out of debt is all about modifying your behavior. You need a plan that shows you the progress you’re making. That’s what the debt snowball is. Instead of automatically paying on the loan with the big rate, you list your debts smallest to largest by amount owed. This is the key to you not falling off the wagon…

Read the rest of Chris’ post here.

Because your student loan debt and mortgage are essentially equal in terms of balance, interest rate and tax deductible eligibility, I’d look at the decision of which to pay off first from more of an emotional or personal perspective.

Student loan debt is unsecured debt, meaning you can’t sell something to pay it off. You also can’t get rid of federally guaranteed student loan debt by declaring bankruptcy. You can’t “downsize” into a smaller student loan, and now that you’ve already consolidated, you can’t refinance down the line to lower your payment. That means you are pretty much stuck with it

Some may argue that you are just as stuck in a mortgage these days, as it’s generally harder to sell a home in this market. But that’s not true in all cases, and if you have even a small bit of equity, you could afford to negotiate a price that would attract buyers in a crunch.

If it were up to me, I’d start whittling away at the student loan debt before paying off the mortgage. I would only do so after establishing a solid emergency fund (our family’s goal is 6-12 months of basic, household expenses…closer to 12 months). With a large family, I’m concerned you do not have enough put away for emergencies.

With a fully-funded emergency fund parked in a high-yielding, safe savings account, I’d then look to put away money for my own retirement (Dave recommends 15% of your income), and then begin setting aside some for the kids’ college – well, with six kids it might mean setting aside A LOT for college!

Continue to make your mortgage payment and minimum student loan payment until these other goals are achieved. By that time, your household income will likely have increased a bit, and you can throw even more each month towards paying off the student loan debt early. When that debt is cleared, take the money you used to send to Sallie Mae and add it to your mortgage principal.

Have a realistic, long-term goal to be 100% debt free, but do challenge yourself. If the goal date is too “long-term,” it may never get done.

Good luck on your journey to debt freedom – it’s a tough hill to climb, but the view from the top sure is sweet!

Ask the Readers: Any additional advice for Jackie? What would you do if you were in her shoes?

Comments

  1. I didn’t think you had to itemize in order to deduct student loan interest on your taxes? I’ve paid mine off, but it seemed like the e-file programs I’ve used have had me plug in those numbers to reduce my taxable income (or something of the sort). I only had to pay a tiny bit of interest on the tail end of my student loans this year, and it was startling when I DIDN’T have that coming out of my tax burden.

  2. Wendy,

    The e-file taxes always have you fill everything in just to see if you qualify for an itemized deduction. If you don’t, your interest doesn’t matter.

  3. Wendy’s right: student loan interest is an “above the line” deduction, meaning you don’t have to itemize you to take it.

    I would focus on the student loans, since you can’t get rid of that debt.

  4. Please build up that emergency savings to at least 3 months’ worth of expenses, but go ahead and get to 6 if it makes you more comfortable. It is going to take a long time to pay off those debts, and a cushion would help so much.

    Is your mortgage a 15 or 20 or 30-year?

  5. I agree with Kacie, a emergency fund that can cover 6 month of your monthly expenses is a must. $1000 in savings won’t even cover your mortgage payment for a month. Unexpected expenditures like fixing your car can destroy your emergency fund if its only $1000.00. I use to work for the bank as a mortgage underwriter, to get approval for most loans you also need at least 6 month reserves to qualify for approval.

  6. Completely agree that the student loan should be first since it’s not bankrupt able. Also agree that first you should raise your emergency cash. I’ve chosen about $5,000 as my checking approximate minimum balance. I’m down to $111,000 first mortgage and $40,000 remaining home equity credit line. So after paying bills on payday, any excess in checking over $5,000 gets sent to the HECL. Makes it simple. Sometimes I accumulate a little side savings for a vacation or something we want to buy, rather than pay down the HECL for a month or two.

  7. I’m curious to know how old the kids are, and if any of the student loans were for their education, or only for the parents? What plans are in place for the kids education?
    My mortgage is through ING, and the rates are excellent. I’ve reset (rather then refinance) twice to lower interest rate which frees up some cash for other expenses.
    Congratulations for feeding/clothing/housing 8 people on $80,000 a year! .

  8. For the Mortgage Vs Student Loan Debt, I’d probably focus on getting rid of the Student Loan debt since it is pretty much impossible to wipe from your slate.

    Both have tax deductible interest, but your mortgage has a higher rate and for me mentally, carrying mortgage debt is a little easier on the mind than any other kind of debt.

  9. First I would build up that EF. $1000 for a family with 6 kids is no where near enough. You should have anywhere between 3 months to a year in savings. Before paying one more cent than you have to on the SL or mortgage get the EF up to 3 months. Then put a line item in for savings for the EF and then with the remaining money start paying off your mortgage. Why are you paying the lower interest debt instead of the higher? People may say that the SL cannot be removed using bankruptcy but you are not going to let your house go either, you need it . Also, SL’s can be put on forbearance if something happens to your job.

  10. I agree. Get that student loan taken care of as agressively as possible after a larger emergency fund is in place for all the reasons Jason listed as well as the emotional baggage that a loan on personal improvement (like schooling) usually comes with! You will need a roof over your head anyways, so the mortgage can take it’s natural course without as much $$ remorse.
    $1000 is a start but not enough of an emergency fund when you have a house, vehicles and 6 kids… much bigger emergencies are just begging to happen that could easily throw debt back into the equation!
    Have fun and good luck.

  11. I would build up a larger emergency fund first given your family commitments. I have mixed feelings about which to pay off first because if you ever lost your job, you can defer student loan payments whereas you cannot defer your mortgage. Normally I would pay everything before a mortgage.

  12. The interest deduction income limitations on student loans is considerably less, but the interest rates are very very low. I would probably recommend paying down the student loans more aggressively than the mortgage, mostly because they are unsecured as you said. Personally, I would pay the the typical monthly payment, and then invest the extra money, people dont understand that this could in fact get you out of debt quicker.

  13. Pay off the student loan! The higher interest rate is costing you over time it only makes since to get that paid off as soon as possible. A savings/emergency fund would be nice in a perfect world but I know in our house its hard to come by. Don’t pay out more than you think can be handled, there are always things that come up and the every day bills as well.

  14. I’m probably the dumb guy but I had my mortgage for about a year before I realized that 4.875% is really nowhere even close to what I thought it was. Here I am thinking it’s like interest on a CD. I never did completely figure out “4.875% of what?”. I payed my house of in less than 6 years so I don’t really remember the details but out of a monthly payment the principal was more like 20%, interest was like 70% and insurance and property tax made up the remainder (don’t quote me on the specifics but it was something crazy like that). I understand that the interest decreases and the principal increases over time but even looking at the last payment on an amortization schedule it wasn’t close to 4.875%. I never had any student loans so i don’t know how they work but I’m guessing they don’t charge interest like they do on a mortgage. And if they don’t then you gotta pay off the mortgage first. It’s absolutely insane to pay that kind of interest on a mortgage just for the pleasure of borrowing a banks money.

  15. IMHO,

    I am in a similar situation with both 6 figures in mortgage and student loan debt but with a 1 year E-fund (3 months cash+12 months in a conservative bond fund), single no kids, and lower income.

    1. Build up a much larger E-fund. Agree with all of the above statements.
    2. Save 15% for your retirement. 15% would be the minimum, the amount needed maybe higher depending on age. Read boogleheads.com for more info.
    3. Put away cash for education for your kids.
    4. Pay off the mortgage then the student loans

    Reasoning – If things get tight, and they very likely will, as stuff happens to us all, the banks are not very flexible. The student loans can be deferred or payments reduced if needed.
    Personal opinion: Interest rates and inflation will be higher moving forward, those two debts allow you some hedging.

    PS: I hate debt, but cash is flexibility.

    • I agree with Tim and my wife and I are in a similar boat. Six figure student debt, mortgage and household income, all about the same amount.

      I would change the order given your situation…

      1. Build up a 3-6 months of expenses emergency fund.
      2*. Save ~15% of your income for retirement (esp. if you are offered a match), I think it is important to start earlier than later, especially as I see the market recovering over the next 10 years (rates likely >4.5% annual return).
      2. Payoff student loans
      3. Payoff Mortgage
      4. Help kids with College (at least partially)

      I would save for retirement(2*) while doing 2, 3, 4, especially if you have a match. The kids college should come last or possibly to a small extent concurrently. Your kids can take loans our for school but you can’t for retirement. You can always help them pay down debt later out of your 401K.

      • I agree with Tim. We paid off home first. Lower interest, the required payments are also lower. In the event something bad happend, we would only have to pay $500 a month.
        Additionally, forbid something bad happens to my wife, I am not responsible to pay off her $150k student loan.
        The house is now paid off, so we are putting all focus on the student loan.
        Whichever way keeps your intinsity up, go with it. The numbers put us about $2000 better doing house first though.

    • I agree with Tim. If things really get down to crunch time the student loans payments can be reduced. Your education cannot be foreclosed upon, the house is another matter. But the most important aspect is to really beef up the savings/emergency fund. $1,000 just isn’t close to being enough. I would however, put the college savings for the kids behind paying off the current student loans.

          • They can’t garnish your wages for a student loan if you are unemployed and have no wages can they?
            If you lose your job and your house is paid off I think you are better off than if you lose your job and your student loan is paid off.
            Filing bankrupt is ths last thing I would want to do, so the fact student loans are not bankruptable does not factor in my decision. It is my responsibility to pay back money that is loaned, however if something happens to my wife I am not repsonsible for her student loan debt.

  16. You have to look at it this way. You can either pay down your debt now or worry about it later. Personally I would rather just think about how I will retire down the road than try and pay for any lingering debts.

  17. I wouldn’t pay off either. As Jason said, you can walk from the mortgage, but not the student loans. I think it’d be wise to deal with the minimal cost of borrowing on the mortgage, and instead put money into a default-sheltered account like an IRA/401k (depends on your state laws).

  18. I personally paid off my loans before I even started saving for a downpayment for a house, so I also vote for student loans first, housing second. I couldn’t stomach getting into more debt until I had my school loans paid. Plus I’d beef up the emergency fund. $1000 doesn’t go that far with such a large family.

  19. Rick and Tim bring up good points. If you look at the amort schedule for a mortgage you will see that the first 1/2 of the payments are mostly interest. In the first year of a mortgage you are paying close to 80% interest on every payment. So for a $1000 mortgage you are actually only paying $200 on the principal. If you can pay an extra $200, you cut a month off the mortgage and save $800. Granted this is in the first year. As the principal gets paid down you pay less and less interest every payment.
    What I did was make extra payments on my 20 year mortgage until I have 5 years left. I then stopped paying extra as the payoff gets smaller. For instance with 5 years remaining the interest is less than 20% of the total monthly payment.
    If I was in your shoes I would pay down the mortgage first. As Tim pointed out your education can’t be foreclosed on. Also if you are in the first 1/2 of the mortgage you have the potential to cut quite a few payments off the end.

  20. My wife and I are in the same situation, both the mortgage and student loans are about the same, the only difference is that i am in the military and next year we will leave our house and rent it. so my thought process is to pay off the mortgage first so the rent becomes another income and then pay off the student loans. On the other hand it is true that you can’t walk away from the house, but being in the military work is very stable. Any thoughts???

Leave a Comment

Your email address will not be published. Required fields are marked *

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>