I saw the following questioned asked of Mary Holm in one of her recent columns (NZ Herald):
Q: I have a student loan and I want to buy a house. I have a cash deposit, so I’m considering paying off my loan in full while using the remainder of the cash as my house deposit (as I have enough to do both). But I’m not sure if that’s a good idea or not.
The student loan is interest-free, but it actually makes my weekly cash flow smaller by about $100, due to compulsory repayments. Would it make more sense to pay the loan off now, to free up cash flow to enable me to better afford to live and pay a mortgage?
I imagine this is a common question for young first home buyers so I wanted to discuss it here too. First up is Mary’s response below, followed by some thoughts of my own.
Note: Mary is a fantastic columnist and I enjoy reading her Q&A style advice each week. It is worth noting that much of her investment advice appears to be aimed towards older investors as lots of the questions seem to come from those in the ‘baby boomer’ category. That being said, I find myself agreeing with her advice more often than not.
“First, let’s set aside the ethical issue of whether you should repay the student loan. Some would say you should, because the lack of interest is subsidised by other taxpayers. But there are counter-arguments.
Given you haven’t repaid your loan so far, I’ll assume you don’t feel obliged to do so. So does it make sense financially to repay the loan now? The answer is no.
Assuming you don’t repay it, once you’ve bought the house you’ll have two debts: the mortgage at an interest rate of, say, 5 per cent, and your student loan with zero interest.
A basic money rule is to always repay a higher-interest loan first. This also applies to credit card or other high-interest debt. Interest eats into your wealth, and the higher the rate the more it gobbles. So getting rid of interest payments, the highest first, preserves your wealth.
So you should put the money you had planned to use to pay off your student loan into mortgage repayments instead. How?
One way is to simply make a bigger deposit on your house. You’ll then pay less interest over the life of the mortgage and pay it off faster.
However, if you’re worried about cash flow, because of compulsory student loan repayments taken out of your pay, it might be better to just stick with your original house deposit, and make part or all of your mortgage a revolving credit mortgage.
With that type of mortgage, you reduce the amount you owe by depositing any money you have sitting around into the mortgage account. You then pay interest on the reduced daily balance.
For example, if you get your income deposited into your revolving credit mortgage account, it reduces the mortgage interest until you withdraw the money for day-to-day spending.
The idea would be to also deposit the money you had planned to use to pay off the student loan.
Reducing a debt on which you’re paying 5 per cent is the same as earning 5 per cent after tax and fees on that money. That’s a good deal.
And if you were struggling to get by some weeks, you could withdraw what you need, but leave the rest in there doing its interest reduction work.
Meanwhile, you should be paying down the mortgage regularly. With lower interest, more can go into principal repayments, speeding the day you repay the mortgage in full.
Another option is to do a bit of both, a bigger deposit and a revolving credit mortgage. Discuss what’s best with your mortgage lender.”
You can read the full article here.
In my opinion this is fantastic advice. Some lenders will ask you to pay your student loan off first before getting finance approval but if you can leave it there you should. The compulsory payments will still go through so it will eventually get paid off. In the meantime you can put any surplus money into paying off your mortgage.
The revolving credit account is also an excellent idea as long as you are good with money. There is no point having any savings in a term deposit account earning 2 or 3% per year while you have a mortgage on your own home costing you 5% in interest. You should ideally pay down all personal debt before having savings elsewhere. Paying off your outstanding mortgage (assuming an interest rate of 5%) is like putting your money in a term deposit at 7 or 8%, because you have to take into account that you will pay tax on any returns from savings or share investments.
As Mary says: Always repay a higher interest rate loan first. Top priority should be any credit card debt, followed by vehicle finance, personal loans, hire purchase arrangements. Pay these off in full before putting any extra money into your mortgage or any term deposit type savings option. If you need money for a car or other large purchase, take it out of your revolving credit account (so you are only paying 5% interest instead of 17%+).
Note: The same argument doesn’t apply to investment property debt (as the losses are tax deductible), just the debt on your own personal home.
Learning the relationship between debt and savings and how interest rates work is probably the most important financial principle I ever learned.
Stay safe out there!
Andrew Duncan – Real Estate Blogger
Who am I?
After 10 years marketing real estate in Wellington I took most of 2016 off to travel the world with my Wife, Annah. We are currently based in Auckland looking at new opportunities in the real estate world. If you are looking for an agent to sell your home (I still know a few good ones), a speaker to inspire your team or just a friend to talk to, send me an email and get in touch. I would love to hear from you.
THOUGHT OF THE WEEK:
“Life is 10% what happens to you and 90% how you react to it”