Save for the House or Prepay the Education Loans?

From Eric: “Here’s our situation. My wife and I just finished getting our credit card balance down to $0. I have one year left on a car loan at 7.5%, ten years left on three education loans at 8-9%, and we both do pretty well, so we have about $1,800 per month left over after expenses. We are trying to put money away for a down payment for a house next year (we have about $10,000 put away already). The question is, should we put everything away for the house, start pre-paying some of the loans, or a combination of both?”

A.T.: Your answer will likely be better than mine, because you will give it/have given it hours of thought. But here’s the 30-second reaction:

Good for you re the credit cards. And good for you re the car … just keep paying the monthly payments and then, with luck, keep driving an old car with no payments. (At which point you may have $2200/month left after expenses.)

From a numbers point of view, if you expect the house you buy to appreciate at 3% a year (say), then on a 20% down payment, your investment is appreciating at 15% a year because of the leverage. And to earn 15% is better than the 9% tax free you earn prepaying your education loan.

Then again, the house will have lots of extra expenses versus renting, so in figuring whether it will appreciate 3% a year, you should try to subtract from the expected appreciation the extra costs of home ownership.

(This is easier said than done, because (a) you can’t know for sure how much extra, if anything, owning will cost versus renting (i.e., when you might need a new boiler); (b) you should adjust your calculations for taxes (on which you will get a break for the mortgage interest and property taxes); (c) you should allow for the possibility rents might rise faster than your home-ownership costs (so that renting might one day seem more expensive than owning); (d) you should not “charge” to this equation any extra happiness you derive from owning the home (charge it to “spending” rather than investing, as no one says you’re not allowed to spend some extra money to have a happier life); and (e)how the heck can you know how much the home will appreciate?)

Then again then again, the larger the down payment you save up, the better loan terms you are likely to be able to get. If you can put down 20% or more, you may not have to pay for mortgage insurance — and that can save you a pretty penny, also. Another case for saving extra hard for the house.

In short, there is so much guesswork here, you should probably do what you want; i.e., probably save up for the home now (much more fun) and then, as soon as you can thereafter, start earning 9% tax free and risk free by prepaying the education loan.

(I like to think that apart from all this, you are also making steady contributions to employer-matched retirement plans, with much or all of that money being steadily added to your holdings of stocks here and abroad.)