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Focusing on debt, but which one

Chris Farrell Dec 6, 2011

Question: My husband and I have extra money each month, a healthy emergency savings account, and we save for retirement through our work plans. (I should point out we are in our 20s.)  We recently bought a home and now have a mortgage of $130,000 at 4 percent interest. We also have approximately $80,000 in student loan debt for our graduate degrees at 6.8 percent interest.

With our extra spending money each month, should we tackle the student loan debt first? Pay down the mortgage? Both? Or some other option? Since our mortgage comes with a tax deduction I’m inclined to say student loan debt, but I’d love to hear other opinions. Carolyn, Duluth, MN 

Answer: In a very real sense, you can’t go wrong if you decide to target the mortgage, student loans or a combination of the two. You’re already saving for retirement and emergencies. Now, you want to accelerate debt payments. And you’re in your 20s. Bravo. 

By the way, student loan interest is tax deductible. However, it comes with a number of important caveats and limitations, especially compared to the mortgage interest deduction. You can take the student loan interest deduction whether or not you itemize your taxes.  

The maximum amount of student loan interest you can claim as a tax deduction is $2,500. Like so many deductions these days, the tax break phases out depending on your income. Married joint filers can take maximum advantage of the deduction if their adjusted gross income is under $120,000. The comparable figure for single filers is $60,000.  The benefit phases out until you can’t use it once your joint adjusted gross income is $150,000 ($75,000 for single filers). In 2013, the student loan interest tax deduction will be only available for the first 5 years of loan repayment unless Congress rewrites the rule book. Here is the IRS publication on the deduction.  

What would I do in your circumstances? I would concentrate on paying down the student loan debt with its 6.8 percent rate of interest. Get rid of the higher rate debt first. This assumes you truly have a healthy emergency savings/opportunity fund. My alternative suggestion is to put some of the extra savings toward the emergency fund/opportunity fund. (It’s always good to build it up when you have the income.) Then, put the remainder toward accelerating your student loan debt repayments.

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