When my wife and I got married, one of the first things that we did was figure out how to join our finances. Along with assets, we also had to consider our various liability accounts. The loans that we're still paying off are the student loan and the home mortgage loan. So, what is the best strategy for student and home mortgage loan payoff?
When my wife and I got married back in 2014, one of the first things that we did was figure out how to join our finances. Along with assets, such as checking accounts, savings accounts, IRAs, and 401ks, we also had to consider our various
liability accounts. Back then, these liability accounts included some higher interest credit card debt and student and car loans, both of which carried a lower interest rate. Then, in late 2014, we added a home mortgage loan to our liability mix.
Since 2014, I am happy to report that we have fully paid off the high-interest credit card debt. This credit card debt was paid off by selling off some of my Vanguard taxable account's mutual fund shares to "destroy" the debt with one lump-sum payment. Further, we successfully paid off the car loan by simply sticking to the 36-month payment schedule.
The loan's that are left, and that we are still paying off, are the student loan and the home mortgage loan. And as such, I wanted to discuss my strategy of paying off these loans, as well as the progress we have made so far in today's post.
Student Loan Payoff Status
Back when I was in graduate school with reduced cash-flow, we periodically called my wife's student loan administrator to negotiate lower rates and a temporary payment relief arrangement. After graduate school, we no longer needed the payment relief and began paying the regular payment levels once the relief period expired. However, the lower interest rate we negotiated (3% annual) is still in place.
According to Nerdwallet, fixed student loan interest rates currently have a pretty large range from 3 - 15%. As such, I am still a firm believer in trying to negotiate down your interest rate if you haven't done so yet.
The original loan amount was $17,691.78, and the current principal stands at $7,392.56. As such, we've currently paid off about 60% of the original loan amount.
Home Mortgage Loan Status
When we moved to Colorado in 2014, we took out a home mortgage loan to purchase a 4 bedroom / 3 bath / 1823 square foot single family home for $250,000. The original loan amount was $237,500. While the purchase price was not as low as I'd been used to in Arkansas, it still was a pretty good deal for the aggressively growing Colorado area (and seller's real estate market). The current Zillow estimate value is ~$390,000.
In the economic environment over the past few years, it's been possible to get a loan for a very low and competitive interest rate. According to a site that I like to use for interest rate comparisons, Bankrate, the current home mortgage loan interest rates seem to range from 4.0 - 4.5% annual. For our home loan in late 2014, we went with a 4.25% annual interest rate. Since we only paid 5% down with cash, this interest rate also included a buy-out of private mortgage insurance (PMI). Since the 4.25% interest rate seemed like a pretty good deal for not having to pay PMI, I didn't dig into the mechanics of how the PMI buy-out occurred. However, that would be an interesting topic for a future post (or if anyone reading this can educate me on this!).
Living with this interest rate for the past 3-4 years (and having interest dominate our monthly loan payments during the early period of the loan), our current principal balance is now $221,949.93.
Student and Home Mortgage Loan Payoff Strategy
My overall belief/payoff strategy with student and home mortgage loans is that if the interest rate is low (by low, I mean <= 4-5%), there is not a huge rush or priority to pay off the loan.
This is because I feel that ultimately what matters for financial security is a person's level of assets that can be fairly quickly converted to cash if needed. In other words, you don't want to be "cash-poor" and "student loan/house rich."
As such, my current approach to my wife's student loan and our mortgage is to pay the target monthly installment payment, but no more. Any additional money I have available goes towards investing in my cash savings accounts or index mutual funds.
โFor the student and mortgage loans, these payments are $124 and $1,429.95, respectively. The student loan payment consists solely of principal and interest. The home loan payment is a little more complex in that it consists of $1,168.36 in principal/interest, and the rest of the payment covers insurance and taxes.
Student and Home Mortgage Loan Payoff Mechanics
As mentioned above, my personal preference for low-interest student and home mortgage loan payoff is to not worry about paying off the loans too aggressively.
However, is this personal preference of mine the "best" payoff strategy? In other words, does the math back it up? In order to answer this question, it's beneficial to look deeper into the mechanics involved with paying off a student and home loan.
In a general sense, when you submit a payment (either the target payment or more) towards one of the loans, the loan principal amount is decreased by the amount of the payment minus the current interest charge and any other fees/taxes/insurance. Paying off loan principal is definitely good because it reduces the amount of future interest expenses that will be incurred.
From a total net worth perspective, decreasing the loan principal causes your net worth to increase. However, what could be called your "liquid net worth," the amount of money you can fairly quickly convert to cash, decreases because you paid your money to the loan company.
Let's take a look at some calculations to dissect this further...
Student Loan Payoff Strategy Scenario Analysis
One of my favorite activities to perform in personal finance is scenario analysis.
In the case of paying off my student loan, there are three (3) scenarios I wanted to analyze, with each representing a different payoff strategy listed below:
- Scenario # 1 - Paying the target monthly installment payments, but no more (my preferred strategy). These payments are sourced from your regular job income.
- Scenario # 2 - Paying 1 additional target monthly installment payment in December of each year. These payments are sourced from your regular job income and are intended to mimic the approach of a biweekly mortgage payment plan.
- Scenario # 3 - A lump sum loan payoff with money from an existing investing or savings account.
The table shown below provides a summary of the performance of each scenario. With Scenario # 1, a total of $8,015.20 is required over the lifetime of the loan in order to pay off the liability by March of 2024. Of this amount, $622.64 consists of interest payments. By paying 1 additional monthly installment per year in Scenario # 2, it would save you $56.24 in interest and result in a payoff approximately 6 months earlier. If a single immediate lump sum is paid in Scenario # 3, it would result in a savings of $622.24 in interest.
To me, both the $56.24 and $622.24 seem like "small potatoes" and not really that much of total savings for the loss of liquidity required compared to Scenario # 1.
Furthermore, it's important to think of opportunity cost with the lump sum payoff. If the $7,392.56 lump sum amount was instead invested in a total stock market index mutual fund earning 10% annual, it would result in an ending account value in March 2024 of $12,678.36. Clearly, this quite surpasses the $622.24 savings that results from the lump sum payment approach.
The spreadsheet/calculations for the analysis of the scenarios above can be downloaded by clicking here.
Home Mortgage Loan Payoff Strategy Scenario Analysis
In the case of paying off a home loan, the monetary stakes are a lot higher when compared with a student loan. The loan term is much longer (30 years vs. less than 10 years), and the loan principal is generally much higher. Both of these factors result in much higher levels of interest needing to be paid over the lifetime of the loan.
Since a lump sum payoff of a home loan is generally not possible for normal people, there are only two (2) scenarios I wanted to analyze here. Again, each represents a different payoff strategy as listed below:
- Scenario # 1 - Paying the target monthly installment payments, but no more (my preferred strategy). These payments are sourced from your regular job income.
- Scenario # 2 - Paying 1 additional target monthly installment payment in December of each year. These payments are sourced from your regular job income and are intended to mimic the approach of a biweekly mortgage payment plan.
The table shown below provides a summary of the performance of each scenario. With Scenario # 1, a total of $369,199.90 is required over the lifetime of the loan in order to pay off the liability by June of 2045. Of this amount, an enormous $147,249.97 consists of interest payments. By paying 1 additional monthly installment per year in Scenario # 2, it would save you $22,457.81 in interest of the total ~ 27 year period and result in a payoff approximately 4 years earlier.
Of course, $22,457.81 is a size-able chunk of change. It corresponds to ~ $800 per year over the 27 year period. So, is it worth it to fork over the extra installment payment once per year?
To answer this question, we have to look again at the opportunity cost. If the extra $1,168.36 per year was instead invested in the stock market (again, assuming earning 10% annual), the total account value by December 2041 (when the loan is paid off in Scenario # 2) would be $105,991.02, nearly 5x the money saved in the biweekly mortgage plan.
The spreadsheet/calculations for the analysis of the scenarios above can be downloaded by clicking here.
Conclusions
In the grand scheme of things, paying off a student loan or home mortgage loan in any format makes good financial sense.
Deciding what the best payoff strategy is, however, can vary based on personal preference. The key things I would like for you all to take home from this post are 1) to make sure that you are not "blindly" paying off a loan and 2) are considering the power/flexibility that comes from having access to your money.
Based on the considerations and calculations above, my personal preference remains to stick with Scenario # 1 and pay the monthly required installments for my home mortgage and student loan (but no more).
***Photo courtesy of https://www.flickr.com/photos/neilspicys/2349758944/in/
