Debt incurred for the acquisition of an asset that should add to one’s wealth, such as a mortgage or a student loan, is commonly referred to as good debt. Conversely, bad debt refers to consumer loans and credit card balances built up to finance items that quickly lose value.
Deficits, no matter how they’re categorized, must be repaid. And if you have a little extra cash each month, you may wonder, Should I speed up payments on my home or school loans? How about if I ask which one I should prioritize paying off?
Choosing Between Student Loan Repayment and Mortgage Debt
There is widespread disagreement regarding whether or not borrowers should prepay large amounts of debt such as student loans or mortgages, but there is much less confusion about when they should not.
You shouldn’t make any additional payments toward either of these obligations until you’ve done the following:
- Cancel out all consumer debt. Before focusing on your mortgage or student loan, you should always pay off any high-interest debt, such as a vehicle loan, credit card balances, personal loans, or anything else that isn’t tax deductible.
- Start a Savings Account just for emergencies. Keep yourself from having to take on credit card debt in the event of an emergency by keeping three to six months’ worth of living expenses in an emergency fund. If you have extra money but can’t afford to manage an emergency, it’s not a good idea to put it toward paying off your home or school loans. You can earn 2.30% APY on a CIT Bank Savings Builder account if you don’t already have an emergency fund set up.
- Participate in your company’s 401(k) plan by contributing up to the matching amount. If your employer offers a matching contribution to your retirement account, but you aren’t putting away at least the amount they are, you’re throwing away free money.
The decision to prepay student loans or a mortgage gets more complicated if you are already in good financial standing, have no outstanding debts, and are contributing to your employer’s 401(k) match.
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Why You Should Pay Off Your Debts Early
There are many advantages to eliminating debt like student loans and mortgages early. When you pay off your home or school loans, for instance, you gain access to the following advantages:
- Eliminating Interest Costs Saves Money. Although the interest paid on mortgages and student loans may be deducted from your taxable income (if your income is below a particular threshold), this deduction will not go far toward offsetting these expenses. Paying interest is a waste of money, but earning interest on savings is a sure bet.
more independence from financial constraints. A person’s financial options are unrestricted when neither a mortgage nor student loan payments must be made each month. - Lower Danger. You need a source of income that exceeds your total monthly debt obligations if you have any. If you don’t have any outstanding debt, you won’t be at risk of losing your home or destroying your credit if you lose your job, become disabled, or have any other temporary reduction in income.
- Payment in Full of All Nondischargeable Debt. Though bankruptcy is an option for dealing with some obligations, educational loans cannot be eliminated through this process. For the same reason, if you have a mortgage and are behind on payments, filing for bankruptcy will not help you. Paying down home and student loan debt is the only way to get rid of it.
Arguments Against Early Debt Repayment
While there are advantages to paying off your home or student loans ahead of schedule, there are also many disadvantages to doing so.
A good example:
- The Lowest Interest Debt Includes Student Loans And Mortgages. This is the most compelling case against paying off debt, such as a mortgage or a college loan, early. It is possible to locate assets that pay more in interest than you pay on your debt, thanks to low-interest rates and the opportunity to deduct interest, particularly if you invest in tax-advantaged accounts like a Roth IRA.
- There are costs involved in the form of lost opportunities while making a prepayment. Any profit made from investing can be put back into the market for more returns. Simply said, this is what compound interest is. Investing more of your income when you’re young allows your money to accrue more compound interest, which can have a significant impact on your retirement and long-term savings. If you start saving $100 a month when you’re 20 and keep it up until you’re 40, earning 8% compounded annually, you’ll have almost a million dollars when you retire at 65. With the same amount of money invested from age 30 to 50 and the same rate of return, you would end up with $205,875 less when you turn 65 if you waited to start investing. This is due to the fact that under the second scenario, you would give your money less time to grow before you started withdrawing it in retirement, reducing the amount you would have to remove. If you can afford it, investing for retirement instead of paying off your student loans with an extra $100 per month can make a huge difference.
- The repayment of a loan is an illiquid investment. Once you’ve paid off large debts like a mortgage or school loans, getting that money back might be challenging, making it tough to use in times of necessity or to make up for a drop in income due to job loss. If you have student debts, you can’t get that money back, and selling your home will cost you in commissions and time.
Choose Which to Pay Off First
If you’ve determined that an early payoff is a good idea after considering the benefits and drawbacks, you’ll need to select whether your mortgage or your student loans should be paid off first.
Several variables affect the outcome of this inquiry:
- Your debt’s average interest rate. It is common for consumers to prioritize paying off debts with the highest interest rates first. This isn’t necessarily the greatest plan of action, but it’s not always the worst, either. Remember to take into account the tax implications of the indebtedness. While the interest paid on a mortgage is tax deductible for everyone, the interest paid on a student loan is only partially deductible for those making over $75,000 a year as of 2012. The annual limit for deducting interest on student loans is likewise $2,500. Determine which debt is the most expensive by comparing the effective interest rates you’ll be paying after taxes.
- Each Debt and How Much Is Owed. If you want to stay motivated when paying off your obligations, one suggestion from Dave Ramsey’s approach is to pay off your smaller loans first. If your mortgage is a lot more than your student loan debt, or vice versa, it may make sense to pay off the lesser debt first.
- The Dangers of a Rate Increase or Decrease. Interest rates and mortgage payments on adjustable-rate mortgages can skyrocket when rates increase. It may be prudent to pay off or reduce an adjustable-rate mortgage to a level where refinancing becomes possible.
- Repayment terms that can be adjusted to fit your needs. If you lose your job, become disabled, or need to go back to school while you’re still paying off your student loans, you usually have the option of deferring or forbearing payments. In most circumstances, you won’t be expected to make payments for quite some time, even though interest will continue to accrue. Income-based repayment plans and graded repayment plans are also available options. Since student loans offer so much leeway, have interest that is tax deductible, and have historically low-interest rates, they are rarely a better priority than other forms of debt.
Bottom Line
In the end, only the borrower can decide whether or not to prepay a mortgage or a student loan. Paying off your mortgage or school loans early may be the ideal option if you want to live a debt-free life, are risk-averse, and want a guaranteed return on your investment.
Skipping the early reward can be a good alternative for more aggressive investors who are willing to take on some debt risk.
