Ask Dr. Don
By Don Taylor, Ph.D., CFA • Bankrate.com
Today, Dr. Don explains paying
off student loans and saving with mortgage prepayments.
Paying off student loans
Hi Dr. Don,
I have a significant amount of school loans ($59,000 in a 30-year
federal loan consolidation program, and another $17,000 in a 15-year
loan with 10 years to go). I also have about $75,000 of equity in
my home. I am considering whether to sell my home and move into
a rental property to pay off the school loans. I am also wondering
if I will have any luck trying to negotiate a reduced loan payoff
amount based on a net present value calculation.
Emily Education
Dear Emily,
The loan balance is the net present value of the loan payments.
It reflects the principal outstanding. Multiply the monthly payment
by the number of months remaining to get the total amount of the
payments. Subtract the principal balance from the payment total
and you'll know how much you'll be paying in interest during the
remaining life of the loan. Some of the interest expense on your
student loans may be tax-deductible. Check with your tax professional
or read IRS Publication 970, Tax Benefits for Higher Education.
Tapping the equity in your home will allow you
to pay off most of the loan balances and be out from under those
monthly student loan payments. What will you be spending that money
on instead? You're taking a step backward by becoming a renter.
Don't take that step lightly. I like the idea of using a home equity
loan vs. selling your home -- if you can make it work in your monthly
budget. You shouldn't tap the full $75,000 of equity but you may
be able to pay off the $59,000 loan. All of the interest expense
from the home equity loan should be tax deductible. Compare the
two scenarios and decide.
Smart money.com has a rent/own
calculator that can help you analyze the economics of renting
vs. owning your home. Although it's structured for a first-time
home buyer, the analysis would be relevant for you, too. Don't forget
to include closing costs on the loan, or the moving costs if you
sell.
Saving with mortgage prepayments
Dr. Don,
On a 15-year mortgage for $190,000.00 at 7.625 percent interest,
how much will I save by adding $150 to my monthly mortgage payment
of $1,774.85, and in what year will my mortgage be paid off?
Shorten Up
Dear Shorten,
Use this Bankrate.com loan
calculator to determine how the extra payment shortens the term
of the mortgage. I did, and it shortened your mortgage term by two
years. That resulted in interest savings (before taxes) of nearly
$20,000. After tax, assuming a marginal tax rate of 33 percent,
that savings would be approximately $13,000 because you lost the
tax savings generated by the interest expense.
Now if you had taken that $150 and invested
it in the stock market and earned 9 percent after-tax, the value
of that investment after 13 years would be about $44,000. The loan
payoff then is $39,401.66. So you could pay off the loan and still
have $4,600 in your brokerage account. Plus you keep the tax savings
associated with the interest expense. Assuming a 33 percent marginal
tax rate, that's nearly $7,000 worth of tax savings.
Now, it's true that investments expected to
earn 9 percent after-tax return don't come with guarantees. And
it's also true that investing small dollar amounts monthly can have
high transaction costs that will reduce your portfolio's return.
But this example shows why some investors aren't prepaying their
mortgages -- they're investing instead.
Bankrate.com writers base
their answers on our editorial content and advice of financial professionals.
We make no claims or representations about the accuracy, timeliness or completeness
of such content, advice or the answers provided to you. Our content, advice
and answers are intended only to assist you with your financial decisions. However,
by its nature such information is broad in scope. Your financial situation is
unique, and our content, advice and answers may not be appropriate for your
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final decisions or implementing any financial or investment strategy.
-- Posted: March 10, 2000
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