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?