House Purchase: Pay student loans or put 20% down?

Question

My fiance and I currently have the opportunity to buy our first house for 200k due to a large 19k bonus that will be coming to me from my employer.

We're considering two uses for the additional money (when added to our existing savings). One is putting 25k down (12.5%) and paying off our student loans. The other is putting 40k down to avoid the PMI entirely.

These are my estimates (We have not identified a specific property yet so exact #s aren't possible):

Mortgage Rate - 3.899% 30 year fixed
Insurance - $800/year
Taxes - $3,500/year
PMI - $1,812/year
Our Student Loan Balances (All are Fed loans) - $24,668
Our Potential Student Loan Interest Remaining (if we do the minimum payment) - $4,365

To calculate the mortgage, I've been using the excellent calculator here: http://usmortgagecalculator.org/

With the above numbers, it breaks down like this:
Monthly Payment (12.5% down): $1,334
Monthly Payment (20% down): $1,112 + our current $400 student loan payment = $1,512
Difference in Monthly Payment:$178

Total Cost After 30 years (12.5% down): $459,268 + $24,668 = $483,936
Total Cost After 30 years (20% down): $440,647.89 + ($24,668 + $4,365) = $469,680
Cost Difference After 30 years: $14,255

Assuming my calculations are correct, paying off our student loans now will cost us around $14k over the life of the loan!

So what seems to be a GOOD decision short-term (paying off loans early) actually seems to be a BAD decision long-term on paper.

Given that is our first home, I don't expect to see the mortgage through all 30 years, so I'm not sure if we're really going to lose all of this $14,255. It could just be an illusion that will never come to pass?

Then again, I think of emergency situations like job loss - we can defer our student loans, but falling behind on the mortgage isn't a good option. So then it makes more to "slow pay" the student loans and enjoy the lower mortgage.

What do you all think? Should we go into deeper debt to save money over time or feel good about eliminating debt now to risk losing money long-term?

Answer 1

There are times that the simplest explanation (or analysis) is best.

You show that, for a time, the PMI is $1812/yr. And it's the cost you will incur by sending $15,000 to the student loan instead of using it as a downpayment. 1812/15000 is 12%. The loan is already costing you 4% (I know, 3.899, a rounding error), so in effect, that $15,000 is costing 16%. I doubt the student loan is even double digits.

Use the $15,000 toward the downpayment. Take the $1812 plus the $859 per year saved on the mortgage payment, and throw the $2671 towards the student loan. This is the simple solution. (Note: $15000 at 4% for 30 years is a payment of $71.61 or $859/yr.)

Part of the PMI issue is that PMI gets removed when you hit 80% due to natural amortization. i.e. the timeframe due to normal payments. If you make extra payments, and hit 80% a year after you close, that's nice, but the bank will drag its feet, and the appraisal (at your cost) may come back low. Then what?

Last, without the S/L interest rate and term, I can't calculate the numbers the way your example showed, but don't mix up term and cash flow with actual cost. Say I owed my mom $50000, at zero interest, and $500/mo payment. Sending $50K would "free up" that $500/mo, but there are better uses for that money, such as high interest debt. You propose to create 16% debt in your scenario.

Answer 2

Congratulations on your bonus may many more come your way.

I am having a bit of trouble following your numbers but it seems you are considering PMI for the life of your loan. Once you get below 20% loan to value, you can petition the mortgage company to remove the PMI (with conventional loans; VA and FHA have lifetime PMI).

If it was me, I'd do one of two things. Both involve paying off the student loan now. The savings from the student loan payment will assist you in helping you meet one of the two goals below. Also both involve getting a 15 year fixed.

The first would be to buy the house now, and work like crazy to get rid of the PMI. My goal would be to get rid of this within 18 months.

The second would be to save up enough cash for the 20% down and then buy the house. You'd miss out on the house you are looking at, which is kind of heartbreaking. Who is to say that a better home does not come along at the same price? My goal would be to have the downpayment in 9 months, and really try to have it in 6 months.

Being an old guy that has experience how much of a virtue patience is, I'd recommend the second option.

Answer 3

Don't forget to take into account the tax deductability of the interest and PMI into the equation. Of course, this would based on your current pay rate, and your rates after marriage. Your mentioning the flexibility in future changes is also a key aspect to take into consideration.

Answer 4

The calculations you suggest have some issues, but I think they are not necessary to answer the question:

It sounds like you are buying the house either way. So the question really is simply whether to pay toward your house first or your loan first. In that case, the answer is simple: pay whichever has the highest interest rate first. Make the minimum payment on the other until the first is paid off. Remember this and make it your mantra for the rest of your life. If you have any debts (such as credit cards) that charge a rate higher than the two options you have presented, do them first.

Now, be careful as you compute the interest rates. Most likely you can deduct interest on your mortgage, so its effective interest rate is lower [it is (1-T)*R instead of R, where T is your marginal tax rate]. For a while, the cost of mortgage insurance will make your effective mortgage rate artificially high, but it sounds like you intend to get to that 20% hurdle pretty fast, so my guess is that this is not a big factor.

Congratulations on your bonus and good luck with your new home.