deciding what debt to pay first

Student Loan Plan: Getting Married – Deciding What Debt to Pay First

Michael Lux Student Loan Blog, Student Loan Plan, Student Loans 0 Comments

In this edition of the student loan plan, we take a look at Rita’s student loan situation.  She and her husband-to-be both have six figures of student loan debt.  Their priorities are debt elimination and buying a house, but they don’t know what to do first.  If you want tips for dealing with your student loans, contact us.

Rita writes:

Hi, Student Loan Sherpa! Man am I glad I found your site!

A little about me: I am a 31-year-old woman who just got married. I finished paying off my hefty Navient loans in early 2016.

Between my husband and I, we currently have the following loans:

$115,000 (with interest) at 6.5% in Fed Loans on the income-based repayment (ICR, I believe) in which I currently pay $0 because I don’t make enough (I’m in a line of work that doesn’t qualify for PSLF);

$150,000+ for PSLF (with a $275 monthly payment, 114 payments left); and

$65,000 owed to my in-laws at a 1% rate which we currently pay $100/month (my husband has his PsyD).

We do not currently own a home. We clear about $4,500 a month after taxes; rent is $1030 with water, internet, and cable included. We recently moved cross-country and are getting back on a budget to pay down our loans but are overwhelmed on which loans to pay down ahead of time, which to stay on schedule, etc. For instance, should we pay more aggressively on the $65,000 loan? Or should I pay extra on the $115,000 loan, even though it will be forgiven in 2031? I just don’t know where to put our extra money! And should we also save for a house or forego all of that until loans are paid off?

This is so confusing…

Picking the loan to attack first

In this case the we have two large federal loans and a debt owed to a family member.

From a purely economic perspective, the federal loan that will not be eligible for PSLF is the one for Rita to attack first.  Paying extra towards the PSLF-eligible loan will just reduce the amount that is ultimately forgiven.  However, keep in mind that more than 1 in 3 PSLF applications are rejected, so be sure to understand the PSLF requirements and complete certification forms on a yearly basis.

[Further Reading: Ways to build wealth, fight debt, and save for retirement]

The longer Rita’s federal loan hangs around, the more that will ultimately be spent on interest.  At the current balance an interest rate, Rita will be paying over $7,000 per year in interest alone.

Aggressive Repayment

Rita may want to get aggressive with her student loans right away.  With federal student loans there are two methods to get aggressive.

Method one is to just be aggressive with your payments.  When you have extra money, it is used to pay down the student loans.  The more you pay, the less interest you run into each month, and you attack until the balance is zero.

Method two to aggressively attack federal loans is to refinance them with a private lender at a lower interest rate.  This option is very risky, because you lose all the federal perks by choosing a private lender.  That means no more income based repayment plans.  The advantage is a lower interest rate which makes attacking your debt much easier.

Opting for Flexibility

One option for Rita would be to pay the minimum on all debts and set extra money earned into a savings account or conservative investment (like bonds).

The advantage of this route is that it affords maximum flexibility.  If Rita reaches a point where she knows for certain that the money is best used towards her federal loans, it can be used that way.  If they decide that money is best used for a down payment on a house, it can be used that way.

The disadvantage is that paying the minimum means a lot of interest on your student loans.  Because monthly payments can be much less than the monthly interest, the balances can actually grow considerably.  This damage can be slightly minimized by opting for an income-driven repayment plan like REPAYE.  Choosing REPAYE will result in the loan balance growing at a slower rate.

Paying Back Student Loans to Family

The money Rita owes her in-laws is a complicated situation.

If the money were owed to a bank, we would probably suggest she just make minimum payments for the life of the loan because 1% interest is so low.

However, this money is not owed to a bank, it is owed to family.  This means the debt could have social implications.  Rita’s in-laws may have strong opinions on aggressive repayment or buying a house.  They may expect to get paid back first, or they may not care at all.

The best way to handle this is to probably have a frank discussion about what their expectations are for the money.  Rita can share her options and get their input.  It can be a difficult conversation, but it is the best way to ensure feelings don’t get hurt over money.

Buying a House

The decision on when to buy a house is something that goes far beyond student loans.  However, for purposes of deciding on when to buy a house, we will look at it strictly from an economic perspective.

When you apply for a mortgage to buy a home, there are three main factors that go into how much home you can afford.

  1. How much do you have saved for a down payment?
  2. What is your debt-to-income ratio?
  3. What is your credit score?

The big impact of student loans is that it can crush your debt-to-income ratio (DTI) and make it harder to save money for a down payment.  Paying down smaller student loans can often give a quick boost to your debt-to-income ratio and put you in a better position to qualify for a loan.

In Rita’s case, her and her husband seem to have a pretty high income relative to their monthly debt.  Due to a recent underwriting change, most mortgage lenders will now use IBR payments for determining how much house you can afford.  The catch is that the monthly payment cannot be zero.  Once Rita shows a monthly payment on her student loans, she and her husband may be in pretty good shape from a debt-to-income perspective.  Until she has a monthly payment, lenders normally just use 1% of the loan balance for calculating the DTI.

Once Rita and her husband are both making regular student loan payments, they actually will be in a pretty good position to buy a home.  This is because their payments are based upon their income and not how much they owe.  This is one of the major advantages of federal student loans.

The trick will be keeping their credit score up and setting money aside for a down payment.

However, even if Rita and her husband can qualify for a mortgage, the most important question is whether they want one or not.  Just because you can buy a home does not mean it is a good purchase.

Bottom Line

Rita and her husband owe more than $300,000 in debt.  Paying it off could take decades.

The big advantage that Rita and her husband have is that their debt is very flexible.  Federal student loans have the advantage of income-based repayment plans, and the money owed to the family has a great interest rate.

The key going forward will be to understand the various options that they have and to revisit them whenever circumstances change.

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