Many student loan buyers face a difficult decision when they buy a home.
Mortgage lenders generally require a 20% down payment on the home in order to avoid Private Mortgage Insurance, known as PMI. For this reason, many homebuyers opt to set aside 20% before making a purchase.
The dilemma for student loan borrowers is that each dollar that is used towards a down payment, is a dollar that cannot be used to pay down student loans.
Is it better to pay down student loans and live with PMI?
The short answer is that it depends.
Some borrowers may be tempted to live with PMI for a period of time in order to pay off some of their student loans. The advantage of this route is that borrowers can essentially turn high-interest student loan debt into low-interest mortgage debt. The cost of this maneuver is having to make PMI payments. For those with interest rates above 7 or 8%, it could be tempting.
The problem with making this move is that the decision isn’t one that can be made purely based upon interest rates. Tax implications and personal preferences also need to be considered.
There is an interest rate deduction for both student loans and mortgages. However, these deductions are not created equal.
The mortgage interest deduction is up to $10,000 per year and there is no income cap of phase out. The only limitation is that it can only be used on homes that cost less than $750,000 under the new tax law.
The student loan interest deduction is limited to $2,500 and the benefit starts to phase out for borrowers with AGIs above $65,000 and completely eliminated for single borrowers with and AGI above $80,000. These numbers jump to $135,000 and $165,000 respectively for married filing jointly borrowers.
A final consideration is the fact that only taxpayers who itemize can take advantage of the mortgage interest deduction, but those who take the standard deduction can still claim student loan interest.
Danger of Default
Another concern to keep in mind is the danger of default on two different loan types.
If you don’t pay your mortgage, you will eventually lose your house.
Falling behind on your student loan payments can lead to wage garnishments and devastating credit consequences, but student loan defaults don’t usually result in evictions.
Door Number Three
The PMI, student loan, and mortgage down payment considerations do not have just the two possible options.
Borrowers with high interest student loan debt should also consider refinancing their student loans. By going this route, a larger down payment on a home is possible without committing to long-term high-interest student debt.
Like mortgages, refinancing student loans requires credit approval. For this reason we usually suggest student loan refinancing be done long before the mortgage process starts, or once the loan is closed. If you are considering refinancing student loans while applying for a mortgage, be sure to consult with your mortgage lender to make sure that the student loan process does not cause issues with the mortgage.
Options for paying down existing debt or making a down payment on a home can be confusing.
However, by considering the tax consequences, default risks, and interest rates, consumers can find the solution that best fits their needs.