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Which Debts Should You Prepay First? A 6-Step Plan


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Speaker 1:
podcast friends. I’m Laura Adams, your host and personal finance author, speaker, and consumer advocate. Who’s been producing this show since 2008. Thanks so much for downloading the show and spending a little time with me today. My personal mission and the purpose of this podcast is to give you the knowledge, resources, and motivation to manage your money the best way possible and create a richer life lately. I’ve received several questions about how to prioritize debt and figuring out what you want to pay off. First. This is a pretty big topic. In fact, I wrote an entire book about it called debt-free blueprint, how to get out of debt and build a financial life you love. It was a number one, Amazon new release, and you can find it on Amazon or on other platforms such as Apple books and Google play as a paperback and ebook or an audio book.

So, you know, that book is going to have everything that you need to know, but we’re going to narrow down the topic today by answering a question that came in from Maya, she says, is it better to pay off student loans or a mortgage? First I’m asking for my brother who took out $80,000 in student loans about 20 years ago and has only paid off about $10,000. He recently bought a home in Southern California and took out a 30 year mortgage. That might be as much as 400,000. I don’t know the interest rates he’s paying on these depths, but I think he should pay off his student loans first because the total debt is smaller, older, and can’t be discharged in a bankruptcy. But what do you think, thank you so much for your question and your voicemail, Maya. I like the way you’re thinking about this.

And in general, I would agree that paying off student loans should be prioritized over a mortgage. And I’ll explain why I say that and give you a lot more detail. In this episode, the student loan versus mortgage dilemma is actually a common one. And especially right now, because most federal student loans are in automatic forbearance. And I talked about this in a previous podcast. They’re in forbearance from March 13th to September 30th of this year, 2020 due to the coronavirus economic relief package. That means millions of student loan borrowers suddenly have the option to stop making payments without any adverse financial consequences, such as hurting their credit or getting charged additional interest or fees. If you have qualifying student loans and you’re dealing with a financial hardship due to the pandemic or any other challenge, you may be really grateful to have your payment suspended, but if your finances are in good shape and you don’t have any dangerous debts, such as high rate credit cards or loans, you may be wondering what to do with the extra money.

So just to clarify, if you’ve got any dangerous high interest debts, those are always the ones that you should tackle first. And once you do that, for many people, what they have left is student loans or a mortgage or both. So the idea is, you know, what do you do? What’s your next step? Should you send it to your student loans despite the forbearance or to your mortgage or to some other account? So in today’s podcast, I’m going to help you prioritize your finances so that you use your resources wisely during the pandemic, we’re going to go through a six step plan that I hope will reduce stress and help you reach your financial goals as quickly as possible. And if you want to review everything in today’s show, it’s really easy to do by checking out the show notes. And we also have the complete archive of podcasts in the money girl [email protected].

This is episode number 637 called which debts should you prepay first? Okay. So let’s go through this plan or a process that I hope will help you think through this question. Number one, check your emergency savings. While many people begin by asking which debt to pay off first, that’s not necessarily the right question. Instead. What I want you to do is zoom out and consider the big picture of your financial life. And an excellent place to start is to review your savings. So if you’ve suffered the loss of a job or business income during the pandemic, you’re probably very familiar with how much or little savings you have. But if you haven’t thought about your cash reserve lately, it’s time to reevaluate it. As you answer this debt question, having emergency money is so important because it keeps you from going into debt in the first place.

It keeps you safe during a rough financial patch, or if you have a significant unexpected expense, like a car repair or a medical bill, how much emergency savings you need is different for everyone. If you’re the sole breadwinner for a large family, you may need a bigger financial cushion, then a single person with no dependence and plenty of job opportunities. A good rule of thumb is to accumulate at least 10% of your annual gross income as a cash reserve. So for example, if you earn $50,000, make a goal to maintain at least $5,000 in your emergency fund. Now there’s another standard formula that you’ve probably heard me talk about. It’s based on average, monthly living expenses for this, what you’ll do is add up your essential costs, food, housing, insurance, transportation, and anything else. You have like medication and multiply the total by a reasonable period, such as three to six months.

For example, if your living expenses are $3,000 a month and you want to have a three-month reserve, you need a cash cushion of $9,000. Now, if you have zero savings right now, I know saving $9,000 might seem insurmountable, but all you really need to do is start small, start with a very attainable goal. Maybe it’s saving 1% or 2% of your income each year, or you could start with a tiny target, like $500 or a thousand dollars and increase that target each year until you’ve got a healthy amount of emergency money. So what I’m saying is that it might take you years to build up enough savings and that’s okay. You’ve just got to start somewhere. You’ve just got to get started. So unless Maya’s brother has enough cash in the bank to sustain him and any dependent family members through a financial crisis that lasts for several months, I wouldn’t recommend paying off student loans or a mortgage early.

Your financial wellbeing depends on having cash to meet your living expenses comfortably, not on paying a lender ahead of schedule. If you have enough emergency savings to feel secure for your situation, keep on listening. We’re going to work through the next five steps to help you decide whether to pay down your student loans or your mortgage first. All right, so the second step number two is reach your retirement goals. In addition to saving for potential emergencies, it’s critical to save regularly for your retirement before paying down a student loan or a mortgage early. So if Maya’s brother is not contributing regularly to meet a retirement goal, that’s the next priority that I would recommend for him. So consider this. If you invest $500 a month for 35 years, and you’ve got an average 8% return, you would end up with a very impressive retirement nest egg of more than one point $2 million.

But if you wait until 10 years before retirement to start saving, you would have to invest over $5,000 a month to have a million dollars in the bank. So when it comes to your retirement savings, procrastinating can make the difference between scraping by or having a comfortable lifestyle down the road. You really cannot waste time when it comes to retirement. A good rule of thumb is to invest at least 10% to 15% of your gross income for retirement. For instance, if you earn $50,000 a year, make a goal to contribute at least $5,000 per year to a tax advantage, retirement account, such as an IRA or a retirement plan at work, such as a 401k or a four Oh three B. And if you’re making those payments monthly or quarterly, it, you know, it really doesn’t matter. As long as you’ve got a regular schedule set up to make sure that you’re getting that goal accomplished by the end of the year for 2020, you can contribute up to $19,500 or up to 26,000.

If you’re over age 50 and that’s for a workplace retirement account. Now anyone with earned income, even if you’re self employed can contribute up to $6,000 to an IRA, or even up to 7,000, if you’re over age 50, the earlier you make retirement savings a habit, the better, not only to starting sooner, give you more time to contribute money, but it leverages the power of compounding, which allows growth in your account to earn additional interest. And that’s when you’ll see your retirement account value mushroom, all right, so emergency savings and then retirement savings in place. The third step is have the right insurance. So in addition to building an emergency fund and saving for retirement and essential part of taking control of your finances is having adequate insurance. Many people get into debt in the first place because they don’t have enough of the right kinds of insurance, or they don’t have any insurance at all.

As your career progresses and your net worth increases, you’ll have more income and assets to protect from unexpected events. If you don’t have enough insurance, a catastrophic event could literally wipe out everything that you’ve worked so hard to earn. So make sure you’ve got enough health insurance to protect yourself. And those you love from an illness or an accident jeopardizing your financial security. Also, it’s a good idea to review your auto or your home or renter’s insurance coverage. And by the way, if you’re a renter and you don’t have renter’s insurance, you need to get it. It’s really a bargain for the protection that you get from it. And it only costs about $185 per year on average, across the United States. So it’s a very inexpensive policy and it gives you a whole lot of protection. And if you have family who would be hurt financially, if you died, you need life to protect them.

And if you’re in relatively good health, you might find a term life policy of $500,000. It might only cost you a couple of hundred dollars in premiums per year. Again, that’s a bargain for the benefit that your family would get, and you can get free quotes for many different types of insurance policies using sites like bankrate.com or policygenius.com. Okay. If Maya’s brother is missing critical types of insurance for his lifestyle or his family situation, getting it in place should come before paying off a student loan or a mortgage early. It’s always a good idea to review your insurance needs with a reputable agent or even a financial advisor. If you have one, get a professional who can make sure that you’re not exposed to too much financial risk before we go on, I want to tell you about a quick and fun way that you can help keep the money girl podcast going.

These days. Many of us are doing a lot more online shopping than we used to, but did you know that when you shop on Amazon, you can also support the show and the entire quick and dirty tips network. All you need to do is go to quick and dirty tips.com/amazon. You’ll find a link that can take you right to Amazon with a little tracking code attached that tells Amazon you came from me when you shop and make a purchase using that link, a percentage of your total will make it back to money, girl headquarters without costing you more. And that money helps me and everyone at the network continue to bring you more great episodes. I know you want to hear the best part of shopping on Amazon is that you can find anything, get a brand new iWriter to stay entertained and informed or a new stand mixer to help you experiment more in the kitchen or vitamins and supplements to stay healthy.

Just go to quick and dirty tips.com/amazon to start your next shopping trip. That’s quick and dirty tips.com/amazon. Thanks for supporting the show. All right, moving on to step number four, set other financial goals. So you might be thinking, well, what about other goals? You might have like saving for a child’s education, starting a business, or buying a home. These are wonderful goals to have. If you can afford them once you’ve accounted for the critical things, your emergency savings, your retirement and your insurance needs. So what I would encourage you to do is to make a list of all your financial dreams and goals. What do they cost? How much can you afford to spend on them each month? If those goals are more important to you than paying off student loans or mortgage early, then you should fund those goals. But if you’re more determined to become completely debt free, then go for it.

So in step number five, we’ll kind of get down to the nitty gritty here. Step five is consider your opportunity costs. So once you’ve hit all the financial targets that we’ve covered far, and you’ve got money left over, that’s when it’s time to consider the opportunity costs of using your money to pay off student loans or a mortgage, your opportunity costs is the potential gain you would miss if you used your money for something else such as investing it. So a couple of benefits of both student loans and mortgages that they come with. Very low interest rates. They also come with tax deductions, which makes them relatively inexpensive in the world of debt. That’s why I mentioned that other high interest debts, these might include credit cards, personal loans, and auto loans should always be paid off. First, those types of high interest debts cost you more in interest and they don’t come with any money saving tax deductions.

But what many people overlook is that you may be able to invest your extra money and get a higher return than you could for paying off a student loan or a mortgage. For instance, let’s say you pay off the mortgage, which would give you a guaranteed 4% return. Well, what if you can get a 6% return on an investment portfolio, you would come out ahead by investing and that’s especially true in today’s low interest rate environment. It’s possible to get a significantly higher return. Even if your investment portfolio is quite conservative. Now the downside of investing your extra money, instead of using it to pay down a student loan or a mortgage is that investment returns are not guaranteed. There is always a risk when you invest. So if you decide that an early payoff is right for you, keep listening, we’re going to review several factors to help you know, which type of loan to focus on first.

All right, so now we’re at the final step number six, which is to compare your student loans and mortgage. Once you only have student loans and a mortgage left, and you’ve decided to prepay one of them, instead of investing your extra money, you want to consider the following factors, the interest rate of your loans. As I previously mentioned, you may be eligible to claim tax deductions on these types of loans. So you might be able to get a mortgage interest tax deduction and a student loan interest deduction. If you claim either type of tax deduction, it could reduce your after tax interest rate on those loans by about 1%, the debt with the highest after tax interest rate is typically the best one to pay off first. And you’re also going to look at the amounts you owe. So let’s say you owe significantly less on your student loans and your mortgage eliminating the smaller debt first might feel great.

Then you’d only have one debt leftover. You’d only have your mortgage payoff instead of two loans. You also want to consider the type of loan that you have. If you have an interest only adjustable rate mortgage, which is known as an arm arm with this type of mortgage, you’re only required to pay interest for a period such as several months or several years, then your monthly payments may increase significantly based on market conditions. Even if your adjustable mortgage interest rate is lower than your student loans, it could go up in the future. So you may want to pay it down enough to refinance that mortgage to a fixed rate mortgage, where you would have payments that would not be subject to change. Another consideration is if you have a loan co-signer, if you have a family member or even a friend who co-signed a student loan or a spouse who co-sign your mortgage, they may influence which loan you tackle.

First, for instance, if eliminating a student loan that was co-signed by your parents would help improve their credit or their overall financial situation. You might prioritize that debt over a mortgage. And if you qualify for student loan forgiveness, if you’ve got a federal student loan that can be forgiven after a certain period, there are some that may qualify for 10 year or even for 20 year forgiveness. Prepaying. That loan means you’re going to have less forgiven down the road. So paying more to your mortgage would save you more money. So the terms of your student loan really should play a factor in this decision as well. So as you can see the decision to eliminate debt and in what order it’s not clear cut. There are a lot of variables and mortgages and student loans are some of the best types of debt to have.

If you do have debt in general, they allow you to build wealth by accumulating equity in a home by maybe getting higher paying jobs throughout your lifetime and freeing up income that you can save and invest for the future. In other words, if Maya’s brother uses his excess cash to prepay a low rate mortgage or a student loan, it may do more harm than good. So before you rush to prepay these types of deaths, make sure there isn’t a better use for your money. Being completely debt free is a terrific goal. There’s no doubting that, but keeping inexpensive debt and investing your excess cash for higher returns can make you wealthier. In the end. Only you can decide whether paying off a mortgage or a student loan is the right financial move for you. But I hope this show has given you some things to think about kind of some pros and cons to wait here.

Thanks again to Maya for sending in your question. If you have a money question or an idea for a future show topic, I would love to hear it. You can call in your question or your comment, the number to leave. Your message is (302) 360-4038. Or you can send me an email using my [email protected]. That’s all for now. I’ll talk to you next week until then here’s to living a richer life. Money girl is produced by the audio wizard, Steve Ricky Berg with editorial support from Karen Hertzberg. If you’ve been enjoying the podcast, everyone at QDT would really appreciate it. If you would just take a moment to rate and review the show, you might also like the backlist episodes and show notes that are always [email protected]


Maya asks:

“Is it better to pay off student loans or a mortgage first? I’m asking for my brother, who took out $80,000 in student loans about 20 years ago and has only paid off about $10,000. He recently bought a home in Southern California and took out a 30-year mortgage that might be as much as $400,000. I don’t know the interest rates he’s paying on these debts. I think he should pay off his student loans first because the total debt is smaller, older, and can’t be discharged in a bankruptcy. What do you think?”

Thanks for your question, Maya! This dilemma is common, especially now that most federal student loans are in automatic forbearance from March 13 to September 30, 2020, due to coronavirus-related economic relief. That means millions of student loan borrowers suddenly have the option to stop making payments without adverse financial consequences, such as hurting their credit or getting charged additional interest or fees.

If you have qualifying student loans and you’re dealing with financial hardship due to the pandemic or another challenge, you may be grateful to have your payments suspended. But if your finances are in good shape and you don’t have any dangerous debts, such as high-rate credit cards or loans, you may be wondering what to do with the extra money. Should you send it to your student loans despite the forbearance, to your mortgage, or to some other account?

6 Steps to Decide Whether to Pay Off Student Loans or a Mortgage First

Let’s take a look at how to prioritize your finances and use your resources wisely during the pandemic. This six-step plan will help you make smart decisions and reach your financial goals as quickly as possible.

1. Check your emergency savings

While many people begin by asking which debt to pay off first, that’s not necessarily the right question. Instead, zoom out and consider your financial life’s big picture. An excellent place to start is to review your emergency savings.

If you’ve suffered the loss of a job or business income during the pandemic, you’re probably very familiar with how much or how little savings you have. But if you haven’t thought about your cash reserve lately, it’s time to reevaluate it.

Having emergency money is so important because it keeps you from going into debt in the first place. It keeps you safe during a rough financial patch or if you have a significant unexpected expense, such as a car repair or a medical bill.

How much emergency savings you need is different for everyone. If you’re the sole breadwinner for a large family, you may need a bigger financial cushion than a single person with no dependents and plenty of job opportunities.

A good rule of thumb is to accumulate at least 10% of your annual gross income as a cash reserve. For instance, if you earn $50,000, make a goal to maintain at least $5,000 in your emergency fund.

You might use another standard formula based on average monthly living expenses: Add up your essential costs, such as food, housing, insurance, and transportation, and multiply the total by a reasonable period, such as three to six months. For example, if your living expenses are $3,000 a month and you want a three-month reserve, you need a cash cushion of $9,000.

If you have zero savings, start with a small goal, such as saving 1 to 2% of your income each year. Or you could start with a tiny target like $500 or $1,000 and increase it each year until you have a healthy amount of emergency money. In other words, it might take years to build up enough savings, and that’s okay – just get started!

Unless Maya’s brother has enough cash in the bank to sustain him and any dependent family members through a financial crisis that lasts for several months, I wouldn’t recommend paying off student loans or a mortgage early. Your financial well-being depends on having cash to meet your living expenses comfortably, not on paying a lender ahead of schedule.

If you have enough emergency savings to feel secure for your situation, keep reading. Working through the next four steps will help you decide whether to pay down your student loans or mortgage first.

2. Reach your retirement goals

In addition to saving for potential emergencies, it’s critical to save regularly for your retirement before paying down a student loan or mortgage early. So, if Maya’s brother isn’t contributing regularly to meet a retirement goal, that’s the next priority I’d recommend for him.

Consider this: If you invest $500 a month for 35 years and have an average 8% return, you’ll end up with an impressive retirement nest egg of more than $1.2 million! But if you wait until 10 years before retirement to start saving, you’d have to invest over $5,000 a month to have $1 million in the bank. When it comes to your retirement savings, procrastinating can make the difference between scraping by or have a comfortable lifestyle down the road.

A good rule of thumb is to invest at least 10% to 15% of your gross income for retirement. For instance, if you earn $50,000, make a goal to contribute at least $5,000 per year to a tax-advantaged retirement account, such as an IRA or a retirement plan at work, such as a 401(k) or 403(b).

For 2020, you can contribute up to $19,500, or $26,000 if you’re over age 50, to a workplace retirement account. Anyone with earned income (even the self-employed) can contribute up to $6,000 (or $7,000 if you’re over 50) to an IRA.

The earlier you make retirement savings a habit, the better. Not only does starting sooner give you more time to contribute money, but it leverages the power of compounding, which allows the growth in your account to earn additional interest. That’s when you’ll see your retirement account value mushroom!

3. Have the right insurance

In addition to building an emergency fund and saving for retirement, an essential part of taking control of your finances is having adequate insurance. Many people get into debt in the first place because they don’t have enough of the right kinds of coverage—or they don’t have any insurance at all.

As your career progresses and your net worth increases, you’ll have more income and assets to protect from unexpected events. Without enough insurance, a catastrophic event could wipe out everything you’ve worked so hard to earn.

Make sure you have enough health insurance to protect yourself and those you love from an illness or accident jeopardizing your financial security. Also, review your auto and home or renters insurance coverage. And by the way, if you rent and don’t have renters insurance, you need it. It’s a bargain for the protection you get; it only costs $185 per year on average.

And if you have family who would be hurt financially if you died, you need life insurance to protect them. If you’re in relatively good health, a term life insurance policy for $500,000 might only cost a couple of hundred dollars per year. You can get free quotes for many different types of insurance using sites like Bankrate.com or Policygenius.com.

If Maya’s brother is missing critical types of insurance for his lifestyle and family situation, getting it should come before paying off a student loan or mortgage early. It’s always a good idea to review your insurance needs with a reputable agent or a financial advisor

4. Set other financial goals

But what about other goals you might have, such as saving for a child’s education, starting a business, or buying a home? These are wonderful if you can afford them once you’ve accounted for your emergency savings, retirement, and insurance needs.

Make a list of your financial dreams, what they cost, and how much you can afford to spend on them each month. If they’re more important to you than paying off student loans or a mortgage early, then you should fund them. But if you’re more determined to become completely debt-free, go for it!

5. Consider your opportunity costs

Once you’ve hit the financial targets we’ve covered so far, and you have money left over, it’s time to consider the opportunity costs of using it to pay off your student loans or mortgage. Your opportunity cost is the potential gain you’d miss if you used your money for another purpose, such as investing it.

A couple of benefits of both student loans and mortgages is that they come with low interest rates and tax deductions, making them relatively inexpensive. That’s why other high-interest debts, such as credit cards, personal loans, and auto loans, should always be paid off first. Those debts cost more in interest and don’t come with any money-saving tax deductions.

But many people overlook the ability to invest extra money and get a higher return. For instance, if you pay off the mortgage, you’d receive a 4% guaranteed return. But if you can get 6% on an investment portfolio, you may come out ahead.

Especially in today’s low-interest-rate environment, it’s possible to get a significantly higher return even with a reasonably conservative investment portfolio. The downside of investing extra money, instead of using it to pay down a student loan or mortgage, is that investment returns are not guaranteed.

If you decide an early payoff is right for you, keep reading. We’ll review several factors to help you know which type of loan to focus on first.

6. Compare your student loans and mortgage

Once you have only student loans and a mortgage and you’ve decided to prepay one of them, consider these factors.

The interest rates of your loans. As I mentioned, you may be eligible to claim a mortgage interest tax deduction and a student loan interest deduction. How much savings these deductions give you depends on your income and whether you use Schedule A to itemize deductions on your tax return. If you claim either type of deduction, it could reduce your after-tax interest rate by about 1%. The debt with the highest after-tax interest rate is typically the best one to pay off first.

The amounts you owe. If you owe significantly less on your student loans than your mortgage, eliminating the smaller debt first might feel great. Then you’d only have one debt left to pay off instead of two.

You have an interest-only adjustable-rate mortgage (ARM). With this type of mortgage, you’re only required to pay interest for a period (such as several months or up to several years). Then your monthly payments increase significantly based on market conditions. Even if your ARM interest rate is lower than your student loans, it could go up in the future. You may want to pay it down enough to refinance to a fixed-rate mortgage.

You have a loan cosigner. If you have a family member who cosigned your student loans or a spouse who cosigned your mortgage, they may influence which loan you tackle first. For instance, if eliminating a student loan cosigned by your parents would help improve their credit or overall financial situation, you might prioritize that debt.

You qualify for student loan forgiveness. If you have a federal loan that can be forgiven after a certain period (such as 10 or 20 years), prepaying it means you’ll have less forgiven. Paying more toward your mortgage would save you more.

As you can see, the decision to eliminate debt and in what order, isn’t clear-cut. Mortgages and student loans are some of the best types of debt to have—they allow you to build wealth by accumulating equity in a home, getting higher-paying jobs, and freeing up income you can save and invest.

In other words, if Maya’s brother uses his excess cash to prepay a low-rate mortgage or a student loan, it may do more harm than good. So, before you rush to prepay these types of debts, make sure there isn’t a better use for your money.

Being completely debt-free is a terrific goal, but keeping inexpensive debt and investing your excess cash for higher returns can make you wealthier in the end. Only you can decide whether paying off a mortgage or student loan is the right financial move for you.

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