Perhaps it was the lottery or a final bequest from a long-lost relative.
No matter how you suddenly ended up with a pile of extra cash, you may be wondering whether to target the mortgage or student loan balance.
After all, student loan debt and a mortgage are the biggest debts carried by the average American, and retiring either would make most people ecstatic.
Student Loans and Mortgages: A ‘Good’ Type of Debt
There are some types of debts that are cancerous, such as credit cards, which can grow easily, often have very high interest rates and are not tax deductible. These are the debts the average person should attack first.
That’s not the case with a student loan, which generally has a very low interest rate, creates value over time in your ability to qualify for a higher paying job and is tax deductible.
However, a mortgage is a good debt as well, particularly one with a competitive interest rate. That’s because the interest from mortgages also are tax deductible and the property secured by a mortgage is likely to increase in value over time.
Two Ways to Attack Debt
There are two ways to pay off debt that are most often suggested by financial experts. One is the “snowball” method. Under this technique, encouraged by financial guru Dave Ramsey, an individual attacks the smallest debt first.
This method can be used whether the analysis is focused on mortgages and student loans or whether a variety of different debts are involved. By attacking the debt with the smallest balance, an individual is going to have success fairly quickly.
This is important, according to Ramsey, because it’s exciting to pay off a debt. That enthusiasm makes it easier to stay disciplined. Also, paying off that first bill then frees up additional money to focus on the next smallest debt balance. Most people subscribing to this method would choose to pay off the student loan debt first because of the lower balance.
Play the Numbers Game
The second way many people decide which bills to pay off first relies on a very basic financial principle. Take a look at the interest rates of all your bills and target the bill with the highest interest rate first.
Student loans generally carry a very low interest rate, from about 2.5 percent to 4.5 percent. When deciding between paying down a student loan or a mortgage, choose the debt with the higher interest rate.
A debt with a higher interest rate takes longer to repay because the higher interest rate continually adds larger amounts to the debt. So, when you pay off mortgage early, for example, with a 6 percent interest, you are earning 6 percent for every dollar in debt you retire.
On the school loan, your money wouldn’t go quite as far because of the lower interest rate for many student loans. I’d love to read a comment from anyone who chose to pay off the mortgage first because of this reason.
Choose the Method That Suits You Best
The bottom line in paying down any debt is personally buying in to your debt-reduction choice. If you would find more motivation by relying on the snowball method, go that route.
Targeting the highest interest rate will always save you the most money, but if you don’t have the discipline to see your debt program through to the end, the statistics don’t really matter.
Editor’s Note: My wife and I have a mortgage, but we finished paying off our student loans last year. We had some extra cash and decided that it was best to tackle the low-hanging fruit, even though mathematically, paying on the mortgage probably made more sense. Another factor for us what the fact that we’d owned that debt (student loans) since we left college (over 10 years ago for me).
If you have both of these debts, how are you approaching paying them off? Which first?