Question: My wife and I, both academics, are trying to figure out whether it is wiser at our stage (just married, early 30s) to work on reducing our student-loan debt or save toward a down payment on a house. If that fits in with one of your future columns, I’d be glad for your advice.
Answer: Ah, for richer or poorer, for student debt or mortgage, for love or money — the modern academic couple in a nutshell. To unravel your dilemma requires mastery of the following esoteric and time-honored economic concepts: leverage, smart debt, stupid debt, and Dr. Dementia.
Permit me to explain.
Your aims — paying off student debt and saving for a house — indicate a sensible use of leverage to advance toward sound goals. Leverage? Isn’t that a Wall Street term? And isn’t everyone deleveraging these days?
Not really. All debt, even household debt, may be considered leverage, because it is a tool that allows you to propel yourself toward an objective at a rate faster than you would be able to attain independently. Since you would need to toil for decades at a minimum-wage job to save up enough to pay four years’ of college tuition, borrowing for higher education is legitimate. A bachelor’s degree is a passport to a higher-income bracket, so it justifies the debt to pay for it. A Ph.D. obviously provides no guarantee of employment. Even worthy graduates can flounder in these times. But as the dual-career success of you and your wife illustrates, the scenario still works out for some.
Yet debt is, at best, a necessary evil. No one enjoys shouldering the burden of cumulative interest. Liberation from indentured servitude is an entirely worthy objective. The day you pay off those student loans you will be walking on air. But in your case, it might seem that you are merely treading water, seeking to swap one kind of debt (student) for another (mortgage). Untrue: On both sides of the equation you are strategizing to acquire assets — a credential, a house. That debt, whether accrued or anticipated, counts as smart debt.
Smart debt ultimately advances your net worth. It includes borrowing for education, since credentials tend to bestow a lifetime advantage in earnings and job security. Likewise, borrowing for real estate counts as smart debt, at least in theory, since the asset should appreciate over time. (Never mention this to people who bought in 2006. Apoplexy may result.)
Stupid debt is the reverse. If you, for example, were to take out $14,000 to buy twin all-terrain vehicles for you and your wife to tear up and down the sand dunes, that would be stupid debt. Granted, the ATV’s might provide release from the stresses of the tenure track, but like all vehicles they depreciate the minute they leave the showroom and generate zero income. Borrow for an inessential item that loses value instantly? Nah. Let the plovers nest in peace.
Most consumer debt is stupid debt. Resist its allure and you’ll have solved half the riddle of personal finance.
Now as to whether you should pay down student loans or build up a house fund. What a delightful choice — and not, as you surely realize, a mutually exclusive one. You could do both. So what you’re really asking is: Should we save for a house at a rate equal to that which we pay back our student debt, or should we elevate one priority over the other?
Begin with an emotional inventory. Would freedom from student debt give you and your wife special satisfaction? When your wife receives her loan statements, for example, is it a painful and unwanted reminder of Dr. Dementia, her dissertation adviser at Regret U.? Then retiring the student debt would have value beyond financial emancipation.
Or, on the contrary, would homeownership be the deeply satisfying endpoint? Were you, for example, raised by a single mother who never owned a home and worked two jobs in hopes that she would lay the foundation for her children to achieve a higher level of financial security? Then buying your first home might fulfill a sacred trust. Only you and your wife can determine such intangibles.
Let us assume, however, that the issue is purely financial. To weigh the alternatives intelligently, first examine your student loans. What type did you take out? At what rates? Student loans, while in theory classified as smart debt, can very easily transmogrify into stupid debt if structured in terms unfavorable to you.
Fortunately, most student loans are federal Stafford Loans, one of the best deals in America, awarded without regard to family income, at fixed rates, with no payments required while one is still in school — indeed, not until six months after graduation. The cherry on top is that the interest, including the origination fee, is tax deductible, reducing your taxable income by up to $2,500. (Report it on Form 1098-E; consult IRS Publication 970 for details.)
Stafford Loan rates are reasonable, set at 6 percent this year for undergraduate borrowers, dropping to 5.6 percent next year and 4.5 percent the following year. For graduate students the rate will stay steady at 6.8 percent. (Parents and students, take note: If you anticipate that you will need undergraduate loans in the coming few years, it will be optimal to push the bulk of your borrowing back until 2011-12, if you can.)
What all of that means is that if your student debt is in federal loans, you are in fine shape. Private student loans are another matter. Although they have largely evaporated in the credit crisis, they totaled more than $17-billion in 2006-7. The same tax benefits apply to them as to federal loans, but their interest rates are often double that of federal loans. Moreover, private rates are typically variable, meaning they can be jacked higher.
Finally, if by “student loans” you mean the credit cards on which you charged your pizza, cellphone, and operagoing, then take a close look at their rates, most likely appallingly high.
The rub: If the debt from your student years is held by private lenders or credit-card companies, pay that off as fast as possible. If, however, your debt is in federal student loans, instead tilt toward building up your house fund.
Why the house savings over repaying federal loans? First, because savings are assets. Assets are the goal for which you took out leverage. Second, because once you obtain a home, you will cease throwing money down the rent drain and begin achieving equity (again, assets). Third, because a down payment is a serious hurdle. Banks today typically require 20 percent down for their best rates, a big switch from the years of madness when zero down was permissible. The average American house sells for about $180,000, necessitating $36,000 down. The upshot is that you need to save. To accumulate $36,000 takes six years if you set aside $500 a month. You may need more, since in many places $180,000 buys a mere hovel.
Of course, you could decide to advance toward both goals simultaneously by adding, say, $100 to your student loans’ minimum payment each month and then plowing as much as possible — $1,000 a month or more, if you can float it — into your house fund. That’s what Pennywise would do. Then again, my adviser was not Dr. Dementia. The real answer, newlyweds, is in your hearts.