Should I pay off my student loans or buy a condo?

Question:

My fiancée and I are getting married next month. In addition to paying for the wedding, my parents have offered to either pay off our student loans (about $40,000) or to provide us with an equivalent amount of money for a down-payment on a condo. We are confused as to the best strategy. Which makes the most financial sense? By the way, my father plans to announce either gift during our wedding reception. Do you think this is a good idea?

Answer:

Congratulations on your upcoming wedding!

From a financial perspective, using a wedding present or graduation gift to pay off student loans or as a down payment on a condo or home saves money by avoiding the interest the borrower would otherwise have to pay. Prepaying a student loan is like earning a tax-free return on investment at the student loan’s interest rate. Similarly, a down payment avoids the need to pay interest on the amount of the down payment at the mortgage’s interest rate. So, the decision should be based on whichever option has the highest interest rate, since that will yield the greatest savings.

There are, however, a few complicating details. Interest on both student loans and home mortgages are deductible for federal income tax purposes, so the comparison should be based on the after-tax equivalent interest rates.

  • The student loan interest deduction is an above-the-line exclusion from income for up to $2,500 per year in interest on federal and private student loans. The student loan interest deduction can be claimed even if the borrower does not itemize.
  • Mortgage interest on up to $1 million in mortgage debt and $100,000 in home equity debt may be deducted on the borrower’s federal income tax returns. The borrower must itemize deductions to claim the mortgage interest deduction.

When considering the impact of the interest deductions on the after-tax interest rates, it is important to adjust the home mortgage interest deduction by the amount of the standard deduction that the taxpayer would otherwise have been entitled to claim. On the other hand, if the down payment is at least 20% of the home’s original value, the buyer may be able to avoid paying for private mortgage insurance (PMI), which can cost about 0.3% to 1.5% of the original loan amount per year, depending on the size of the down payment.

Of course, this analysis assumes that the newlywed couple will definitely buy a home in the near future. The student loan debt already exists and, thus, is unavoidable. But, buying a home is not a foregone conclusion. The best strategy may involve using the gift to pay off the student loans and to not buy a home immediately, so that the couple can start off with a clean financial slate. By living debt-free, the couple can avoid the financial stress of having a mortgage and the burden of owning and maintaining real estate. They will be able to save for a house down payment quicker without the student loan debt. This also gives them time to learn each other’s real estate preferences, instead of rushing into a house or condo purchase.

With regard to the father announcing the gift during the wedding reception, that’s his decision. There’s nothing you can do to stop him, other than refusing the gift. Generally, people prefer to keep financial matters private. But, the father wants to share his joy at the marriage, so let him celebrate. Let him say whatever he wants to say. Then, thank him graciously for his generosity and tell him how much your parents and the gift mean to you. Just be glad he isn’t sharing embarrassing stories about you when you were a child.