Figuring out which debt to attack first is always a challenge.
If you have both mortgage debt and student loan debt, there is not an easy approach that should be used 100% of the time.
Circumstances differ from person to person, so it is important to understand the key considerations in making this decision.
Tax Implications
Both student loans and mortgages come with an interest deduction that can be used on your taxes. However, these deductions work very differently.
The biggest difference is that there are significantly more limitations on the student loan interest deduction. For starters, a maximum of $2,500 can be deducted. Additionally, if you make too much money, you cannot claim the student loan interest deduction. If you are single, the maximum modified adjusted gross income is $80,000. For couples, that number is $160,000. Individuals in the 65k to 80k range and couples in the 130k to 160k range are subject to a phase-out, which reduces the benefit. The IRS has a very detailed explanation of the student loan interest deduction rules.
The rules for mortgage interest are far more generous than the student loan interest deduction. There is no income cap and the full deduction can be claimed so long as your house costs less than a million dollars.
One other distinction worth noting is that the student loan interest deduction is above the line, meaning it can be claimed on any return, while the mortgage interest deduction can only be claimed if you itemize.
Finally, state tax programs as it pertains to mortgages can vary greatly. Be sure to understand how your mortgage can affect your property taxes and state income taxes.
Most borrowers will probably find that the mortgage interest deduction is a much bigger benefit and that having it reduces the effective interest rate of the home loan. Put another way, the cost of the interest on your home loan is usually lower because you get a deduction.
Forgiveness Programs
While there are programs to assist borrowers who fall behind on their home payments, the student loan forgiveness programs with the federal government are far more generous.
If you are on an income-driven plan for 20 to 25 years, the remaining balance on your loan could be forgiven. Similarly, if you are employed in public service and make 120 certified eligible payments, your loan balance can be forgiven as part of the Public Service Loan Forgiveness Program.
If there is a possibility that you will be benefiting from either of these programs, putting your extra money towards your mortgage might make more sense.
Consequences of Default
While you have extra cash now, it is still worth considering what might happen if you were to fall on harder times.
If you default on your student loans, it is definitely a bad thing. Your credit will be trashed, and you could end up in court or have your wages garnished.
However, defaulting on your mortgage may be worse. If you can’t pay your mortgage, you risk eviction, in addition to all the negative credit consequences.
The Deciding Factor
For most people, debt is debt. The sooner you can get rid of it, the better.
The fastest way to eliminate debt is to pay off the high-interest debt first. If you are looking to aggressively eliminate all of your debt, paying off whatever carries the highest interest rate (after factoring in taxes) is the smart play.
If you are in this situation it doesn’t really matter what the debt is called. The bad debt is the high-interest debt.
Changing Interest Rates Can Change Your Plan
One other factor that should be considered is the possibility of lowering interest rates on your existing debt. This changes the math and can save thousands each year.
Mortgage interest rates are no longer at historic lows, but they are still very low. Refinancing your home could potentially save a ton of money over the life of the loan. The downside is that there are costs associated with this process, so any savings would have to offset the cost.
Similarly, student loan interest rates can be greatly reduced by student loan refinancing. Unlike mortgage refinancing, this process does not have any transaction costs. In fact, many companies will offer new borrowers cash up front to consolidate their loans. As a result, even a slight decrease in interest rates can be a smart financial move.
Bottom Line
Student loan debt and a mortgage are two very different types of debt, with key differences in tax advantages, programs, and refinancing.
These key differences should all be considered as you put together your plan for debt elimination.
