Which Debt Should I Pay Off First?

couple re-doing home

My husband and I have student loans and mortgage debt (on our primary home and rental properties). Which should we pay down first?

—Stephany Y., Los Angeles, CA

You’ve probably heard student and mortgage debt referred to as “good debt.” That’s because some interest you pay on these loans can be tax-deductible, and the debts are presumably incurred for the purpose of ultimately increasing your net worth. “Bad debt,” on the other hand, includes revolving credit card debt, auto loans, and other consumer debt for purchases that depreciate in value. Obviously, eliminating that debt should be a top priority. Before you pay down good debt, though, consider these questions:

Do you have adequate life and disability insurance?
If you have kids, this is especially important. Protecting your ability to earn income and your family’s well-being should be a priority.

Do you have an adequate emergency fund?
An emergency fund—ideally, with the equivalent of six months of income—can protect you from having to take on bad debt to pay for a big unexpected expense. It doesn’t make sense to use extra money to pay down debt if an emergency could force you into further debt.

Have you contributed at least what your company matches in your 401(k)?
If your employer offers a matching contribution and you aren’t contributing at least the amount matched, you’re essentially giving away free money you’ll want when you retire. This should take precedence over good-debt reduction.

Have you adequately saved towards other important goals?
If you’re planning to pay for college (or private school), start a business, or make some other dream a reality, you may want to put extra money away for that before paying off your good debt.

Once you’ve addressed these, the next question is whether to pay off mortgage debt or student loans first. Consider a few factors:

  • Interest rates on your loans. Usually, paying off the higher-interest debt first is a good idea, but it isn’t always the best idea. It’s important to compare the effective after-tax interest rates on your debt to determine which debt truly costs more. Mortgage interest on your property is usually tax deductible. Mortgage interest on rental property can also be deducted as a rental expense, using the Schedule E tax return form, though only interest on your primary home and a second home that isn't a rental can qualify for a deduction on Schedule A. (Rates and fees on rental property debt can also be more expensive than those on your primary mortgage.) Student loan interest deductions are capped at $2,500 per year and phase out at higher incomes ($75,000 if you file as single, $155,000 if you are married and file jointly).

  • Small versus large debt. Repaying smaller debts before larger ones is easier and can help you stay motivated to continue reducing debt. If you owe significantly less on your student loans than your mortgage (or vice versa), it may make sense to pay off the smaller debt first.

  • Adjustable rate risk. If you have an adjustable rate mortgage (ARM), there is the risk that the interest rate – and monthly payments – will jump when interest rates rise, which they eventually will. You may want to pay down an ARM enough that you can refinance if you need to do so.

  • Repayment flexibility. While this may not be a factor in your case, individuals with student loans can usually postpone payments if necessary due to job loss, disability, or a return to school. In some cases you also have the ability to tie your payments to your income or use a graduated repayment schedule. Keep in mind, though, that your loan interest will continue to accrue regardless of your situation.

Bottom line:
If you are able to deduct the mortgage interest on your primary property, and some of the interest from your student loans, it probably makes sense for you and your husband to pay down the rental property debt first (and start with the higher interest rate-loan), as the interest on that is not deductible. Before paying down that debt, though, be sure that you are well-protected from the risk of bad debt. You might also consult a tax professional before making a final decision.

Editor's Note: This piece has been updated to correct an earlier error. Mortgage interest on rental property can be deducted as a rental expense.

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