Sunday, August 24, 2008

Shifting Debt Around Is Not "Paying It Off"

I recently asked my friend, “DP”, how he was dealing with onerous student loan payments. I was shocked to learn he paid it all off. I asked what was his spectacular debt elimination plan? His answer: "I refinanced my home."

DP sympathized that because I didn’t own my own home, this "debt elimination" solution was unavailable to me. DP also seemed proud of his financial prowess since his interest payments were now tax deductible. (DP’s income exceeds the threshold for student loan interest payment deductions. As is the case with me.)
Excuse me? This is one of my biggest pet peeves: people claiming they “paid off” something when in reality they only shifted one debt to another. Why do so many people believe that by shifting their consumer debt into their mortgage, they’ve somehow “paid off” that debt? They often justify this move by saying their non-tax deductible consumer debt is now tax deductible.

Am I wrong to think that DP is actually losing money due to his “debt solution”? I was curious so I crunched the numbers. Let’s assume he and I both have $104,848 in student loans.

Based upon my snowball debt elimination plan, I expect to pay off my student loans by December 2014. My tax deduction during this period is $0 and I would have paid approximately $21,029 in interest (for the student loan portion only).

I’ll assume that DP rolled his student loans into a 15-year or 30-year mortgage with 6% APR. (For simplicity’s sake, and in DP’s favor, I’m also not calculating the refinance costs.) On the extra $104,848, he would have paid $54,410 and $121,454 in interest respectively. According to this mortgage tax calculator, his tax savings is approximately 4%. Therefore, his net interest payments on his refinanced student loans after the tax deductions are taken into consideration are $52,234 and $116,596, respectively. (This is, of course, a guesstimate since I don’t know what DP’s federal and state tax rates are. I’ve assumed a 25% federal and 9% state tax rate.)

Ummmm…. Am I missing something here? Does the appreciating value of a home somehow negate the difference?

Either way, I guess next time someone suggests I buy a house so I can “pay off” my student loans, I will know better.