To pay off student loans or not to pay off student loans? That is the question

[LaRon Phillips]

Hello,

I had a discussion a few weeks back with some friends about finances and such.  They are both married and are home owners.  I on the other hand am single and still renting.  We are all physicians in our mid 30s living in Chicago.  They asked why I haven't bought a home yet and my reply was that I wanted to pay off my student loan debt first.  They argued that I should only pay the minimum on the loans and that there was no need to wait to become a homeowner since I was financially "ready" to buy now.  They also mentioned that I could invest (e.g. real estate, stocks, etc) that money and get a return that "beats" the 3.12% interest on the loan and "net" a better outcome.  A few beers were involved in this conversation so math and hard numbers were somewhat off limits.  lol.  

I have about $90K in student loans at 3.12%.  My gross income is about $250K.  Savings is about $75K.  401K and IRAs are fully funded.  Expenses are about $5K per month. 

I've heard competing philosophies on the subject but just wanted to get others opinions on it.  Pay off the loan first OR pay the minimum and direct more toward home buying/investing?

Thanks,

LP

[Lumi Ispas]

Hi @LaRon Phillips, 

First of all, as a physician, you should take advantage of the physician loan, which is a no down-payment loan with the lenders not taking in consideration your students loans.

There is only a bank in the city that I know does that type of loan and I can send your their info.

Regarding paying off students loan, I will say buy investments that give you the cash flow to pay the payments on the student loans. At 3.12%, your student loans are almost free money. Most of the economists will say that the inflation runs at around 3% a year, which is almost the interest you are paying on these loans. 

Let's assume you buy a house for $115,000 with 20% down as investment, at an interest rate of 5%, so the loan amount is $92,000 (almost as much as your balance on your student loans), wich will bring you a monthly mortgage payment of $494 + property tax $200 + property insurance $100, a total of $794.00/month expense for this home.

Let's further assume that you are renting this home for $1400, that will give you a $606 cash flow per month.

In the same time, you will get to amortize the $115000 for over 27.5 years, meaning that $4182 will be deducted from your taxable income, and if you are in a 25% tax bracket ( and I bet your in a higher tax bracket based on your income) you will save about $4182 x 25% = $1045 per year, plus, out of the $494 mortgage payment at the end of 12 months your paid about $1500 in principal, meaning your $92000 balance on the loan is down tot $90,500.

So let's see, after the first 12 months, you have a home that if it appreciates at 3% a year, you are in the following situation:

Home worth:                    $118,450

Balance on the loan:         $90,500, ( paid off$1500)

Cash flow:                          $7,272

Saved on tax a min of        $1,045

So at the end of the year your $23000 down-payment brought you back:

$3,450 in appreciation

$7,272  in cash flow

$1,045 in tax savings ( minimum)

$1,500 in principal

Total of $13,267 in cash you gained in 12 months for an investment of $23,000, so you can get your money back in less than two years.

Imagine taking this to the next step of using the 75K as down-payment for a 3-4 flat with more cash flow, more tax deductions, more principal gained, and higher appreciation. 

Will using the 75K towards paying your student loan give you the same return?

And let's keep in mind that the moment you paid off this property, you have an asset that hopefully has appreciated nicely and now the cash flow grows by the amount you used to pay for the mortgage.

At his moment this is what I will do if I were in your place:

Step 1.  Buy a home with a physician loan with no money down, and have the seller pay your closing cost, so you can get the benefit of paying your home off and not your landlords, also to get some more tax write offs as you could use them.

Step 2.  Buy an investment property that will give you further tax advantages and give you the cash flow necessary to pay the payments on your student loans.

Good luck to you and let me know if you have any questions!