Overpay student loan or mortgage first?

Question

I am aged 23 and make £48000 a year. I have 2 sources of debt at the moment, my student loan and a mortgage I have just entered.

Student Loan Details:

Amount: £42775.54
Interest Rate: 5.4%
Monthly Payments: £167
Term: 29 years until destroyed (At current salary, increasing annually at rate of inflation will pay-off in 26 years time)

Mortgage Details:

Amount: £223,125.00
Interest Rate: 1.84% (First 5 years fixed), 4.24% (Variable after first 5 years)
Monthly Payments: £724.16 (First 5 years), £982.43 (Thereafter)
Term: 35 years

I currently save about £750 a month which I put straight into a savings account at 1.5%. I think it is fair to say that on average over the next 35 years I will save about £1000 a month.

I am keen to pay off my debt rather than put money into a savings account.

My question is this: If you were in my situation which debt would you pay off first - The student loan or the mortgage? (or neither and continue savings)

The rate on the student loan is higher, but the monthly interest accrued is higher on the mortgage as it is a greater amount.

I know this thread is now closed but as a supplement I have simulated paying monthly overpayments on my student loan for the remainder of its term at different overpayment amounts, thought this might be of interest to people so here were the results:

Parameters:
- Starting Salary = 48000.0
- Salary % Increase Per Year = 2
- Loan % Interest = 6.3
- Starting Loan Amount = 42775.54
- Loan Term Remaining = 29 years

Answer 1

The rate on the student loan is higher, but the monthly interest accrued is higher on the mortgage as it is a greater amount.

First off, the monthly accrued interest being higher for the mortgage is irrelevant, it really is just the rate that matters. If you put an extra £1000 to the student loans, you'll reduce your interest payments by £54/year. But if you apply it to the mortgage, it's only £18.40 to £42.40 savings in interest per year, so making extra payments towards the student loan is clearly more valuable than making it towards the mortgage in terms of interest saved.

Now, as has been noted, UK student loans gets discharged after some time, 29 more years for you. But, you also state that:

At current salary, increasing annually at rate of inflation will pay-off in 26 years time

Depending on your occupation, the "increasing annually at rate of inflation" may be conservative--for many people, particularly skilled labor right out of school, income increases faster than inflation. Thus, I think even just paying the minimum payment, you'll end up paying it off in less than the 26 years that you've determined (with the caveat that I don't know how the UK calculates the income-based repayment, so it may not be so much less if you're already near the maximum minimum payment).

Because of that, I think there's a high chance that you'll be required to pay it off before the end of the period. And if you think you're going to have to pay it off, paying it off early is definitely what I would do. It's a guaranteed 5.4% return, which is hard to beat.

Essentially, it becomes a trade off between minimizing your total cost or maximizing your financial flexibility. The options I see are, in order from most conservative to most aggressive are:

• Pay the minimum on the student loan and increase savings in a safe savings account. This will probably cost the most in the long term by a significant amount, but put you in a secure place if you lose you job or something catastrophic happens.

• Pay the student loan fairly aggressively, minimizing the total interest paid, and getting a 5.4% return for each pound is pretty good.

• Pay the minimum on the student loan and increase savings in an investment account. Stocks average >7% real returns so this would likely maximize your total net worth in the long run, though stocks are volatile and a much higher risk for only about ~2% extra gain.

Personally, I'd take the middle road, pay down the student loan ASAP, but I think all are legitimate options.

Note: I didn't mention the mortgage, but the same three basic options apply to that, except the lower interest rate makes paying it off less appealing.

Answer 2

The mathematically optimum loan to pay off first is the one with the highest rate. This is knows as the Avalanche Method.

For most people, the emotionally satisfying loan to pay off first is the one with the lowest value. This is known as the Snowball Method.

There are religious wars about which is the Right And Proper Method.

In your case, the decision is a moot point, because your Student Loan meets both criteria. Thus, I would pay it off first.

Answer 3

I am not a financial advisor but I would not suggest paying the student loan early. Student loans in the UK get written off after a set period of time. They are also based on your income so should you have periods of under employment in the future you may not have to pay anything during that period. It has been said many times but UK student loans are essentially a graduate tax.

You may want to consider extra contributions to a pension as you would get 20% of the contribution added as a rebate from HMRC, you could then take a lump sum of this out at age 55 to pay the remaining mortgage.

Also keep in mind inflation is likely to eat the value of the mortgage in the long term (assuming interest rates are somewhat stable) so if your salary keeps up with inflation the debt burden will feel less over time.

Bottom line is to consider what gets the best return with the money you have now.

Answer 4

I would pay down the mortgage, because your student loan will be written off after thirty years regardless of whether or not it has all been repaid. At your current income level, you will repay it all, but if your income should fall then your repayments will reduce and you may well have part of the loan written off.

Answer 5

TL;DR - Get a comfortable safety net n savings, then pay off the student loan.

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The existing answers between them pretty much cover all of my points, but none of them are pulled together in one place. So:

The first point to consider with UK student loans is whether it will get written off or not. You indicate that if your pay rises with inflation, then you would pay it off with about 3 years to spare. As a fresh graduate you are likely to have above inflationary pay increases (though this is of course industry specific) so I'm relatively confident that, provided you stay employed in your current career, you will pay off the loan rather than have it written off. With this in mind you can then treat the student loan as a normal loan for the purposes of paying it off.

The mathematically obvious decision is then to pay off the loan with the highest interest (or put the money into savings if it pays a higher rate). That's currently the student loan. After your fixed term mortgage ends, that'll still be the student loan (based on current rates). And don't forget that you probably won't ever be on the "standard" mortgage rate; you'll find another fixed deal (or a tracker one) as your current 5 year one comes to an end. Obviously we can't predict for sure over 20 years which will have the higher rate, but your type of student loan has a pretty harsh formula for calculating the interest rate, and I'd guess it'll always be the highest rate.

You then need to cover risks: What are the chances you lose a job and need money? Only savings will help with that (no-one's going to let you remortgage when you have no income to pay off the new mortgage). And, as people have pointed out, you don't pay anything on your student loan while unemployed, so could unemployment actually cause it to get wiped out (in which case any overpayments on it were wasted)? Or maybe you just need to pay a big repair bill on your house or car or something. Savings are the best shout for that too. So maybe build up an emergency fund (of an amount you're happy with) before you start paying off the student loan.

Answer 6

I will pay off the mortgage because the student Loan will b written off after some period of time