Numerous loans need to be paid, which one to attack first?

[c3troop]

Hey guys, first time to post, I appreciate any advice on this topic as I'm young and don't fully grasp what I should be doing with my money yet.

My wife and I are making roughly 90k a year (more depending on bonuses and overtime, this year will be close to 120k.)

We're 25 and own two homes, one the home we live in, and one we rent.

Rent House - Owe 103k, loan is 5.5% over 30 years. Home is worth roughly 130k. Monthly payment with all escrow is $985. Rent brings in $1,095. We have only had this rent house for a year and a half so far, and due to numerous items needing to be fixed, we have put back into the house every bit of profit we have recieved thus far.

Current House - Owe 94k, loan is 3.875% over 15 years. Home is worth roughly 130k. Monthly payment is $1,011.

Car - 2011 Jeep Grand Cherokee. Owe 28k, loan is 2.9% over 4 years. Monthly payment $743.

Student Loans - Roughly 16k left, interest rates range from 4.5% to 6.8% on three seperate loans.

We both have 401k's. My wife's company matches her 50% up to 6% so we put in 6% of her paycheck and they match 3%. I work for the government and they do not match so I only contribute 1%. However, I also have a pension that I am forced to pay in 6%. I will be leaving the government as soon as possible, so I will not be retiring with the pension. I will be maxing out both of our Roth IRA's this year (first year for her IRA). My Roth will have $9,000 by February, wife's will have $5,000.

We have $6,000 in an emergency fund. The plan is to leave this $6,000 liquid and invest the $10,000 max in the Roth IRA as an emergency fund (putting one of our Roth's on an aggressive path and one on ultra-conservative). I know I need a 6 month EF, which is what we are working on. Assuming the Roth's can be used for EF if absolutely necessary, we will have $16,000 this year, and $26,000 next year. At $26,000 that will be what we need for 6 months living expense.

We have sunk large quanities of money into both of these homes in the last year to get them down to what we owe on them at the present time. We will have roughly $1500 a month left over to put into one of these loans beginning in January. Which one should we attack first?

My initial thought is to attack the car loan. It is not a tax write off like the student loans and homes, and if we buckle down we could have it paid off in a year and have the extra $743 a month to invest in other places.

I have a pickup that is paid off and will last me at least ten more years.

Also, we're thinking about having kids in 3 years, so our salary would drop to roughly 55k a year. I'm trying to get my ducks in a row so I'm not sinking when we have kids.

So my idea is:
1. Car
2. Student Loans
3. Personal House
4. Rent House

By the way, our ultimate goal is to be debt-free and have a paid off house. I'm not sure how much longer we are going to do the rental thing because it is stressful and ties up alot of our money. We really want to pay off the house we are in now. The loan started at $120,000 two years ago and we are now down to 94k, so we have made a significant dent in it.

Thanks alot I look forward to hearing any advice.

[ktmarvels]

Interestingly we are in a similar boat with nearly the same debt situation as you (primary home, rental, car payment and student loans). We are putting most of our payment toward student loans because it is the highest interest rate. Our next step would be to pay off the car. I don't think we are going to put any/much towards the houses because we will most likely be selling them in about 5 years. I'm slightly torn on this point, however if we can earn greater returns elsewhere (stock market) and/or keep our money more liquid, it probably makes more sense than dumping it into the house.

There are 2 main theories about debt payment. 1. Start with the highest interest rate, and 2. Start with the lowest balance. The first makes more financial sense and the second is more motivating to some people.

The fact that much of your debt can be written off changes the actual interest rate of the loans a little bit (that calculation is beyond me, but I'm sure relates to your tax bracket and other things), but its up to if you want to take that into consideration.

It seems like you are motivated as you are already in a great situation and have already paid off a lot of debt so I would recommend going roughly by interest rate. You do bring up good points on paying off the car first though, so you might want to consider it

[thefrugaltoad]

Roth IRA can't be used as emergency fund until you are 59 1/2. Further you can only withdraw an amount equal to what you put in for that tax year. So here is what I would advise:

1) Emergency Fund
2) Car loan makes sense since it will have big impact on your cash flow and allow you to paydown your student loan quicker.
3) Home Mortgage
4) Investment Mortgage.

If the rental is generating cash flow I would hold on to it as you may have a good chance to some some market appreciation. If you have no cash flow I would sell it.

[disneysteve]

Welcome. Where to start? There is a lot to address here. Let me start by saying I am NOT picking on you but I think it is necessary to point out some problems and mistakes in order to help you create a plan for moving forward and cleaning up the mess. Plus, it is educational to others so that they can avoid getting into similar situations.

1. ALWAYS budget based on your base income not including bonuses and overtime, so in your case, everything should be based on the 90K annual income. We can talk about what to do with the excess income later.

2. Rule of thumb (ROT) for housing: Spend no more than 3 times your annual income and have monthly payments not more than 28% of income. Your monthly payments ($1,011 + $985) come to about 35.5% of income.

3. ROT for cars: If you must take a loan, it should be for no more than 3 years with payments of no more than 10% of income. You have a 4-year loan with a payment of about 13% of income.

4. As you've pointed out, you need a 6-month EF. You haven't shared your full budget but cleaerly 6K is not adequate. Yes you can take money out of a Roth, but don't. Just forget that possibility even exists. Your goal should be to put 10-15% of income into retirement plans for retirement, not to pull it out later because the roof leaks or the car breaks down.

As for your actual question about order of debt, I disagree with your plan as it doesn't take interest rates into account which should absolutely be part of the plan. So to reorder your list, I would do the following:

1. Highest rate student loans (6.8%)
2. Rental house (5.5%)
3. Lowest rate student loans (4.5%)
4. Personal house (3.875%)
5. Car (2.9%)

That said, that isn't what I would actually do. Since you are not upside down on the rental and it makes you little if any profit, I really so no point in owning it at this stage in your lives. I would sell it. Hopefully, you can walk away with 15-20K. Use that to knock out the student loans. Then attack the car loan and vow to never buy a new car again or borrow to buy a car again. That will leave just your personal mortgage. Just make the regular monthly payments on that. Build up your EF. Get your retirement savings up to 15%.

Along the way, when extra money comes in from OT or bonuses, use it to pay down the debt quicker or get the EF up to where it needs to be once the debt is gone.

[disneysteve]

Originally Posted by thefrugaltoad

Roth IRA can't be used as emergency fund until you are 59 1/2.

This is not correct. You can withdraw your contributions (but not your earnings) at any time for any reason. It doesn't matter how old you are.

[disneysteve]

Originally Posted by thefrugaltoad

2) Car loan makes sense since it will have big impact on your cash flow and allow you to paydown your student loan quicker.

Nope. It does not make financial sense to pay the 2.9% loan before the 6.8% loan. You will pay off the student loan quicker if you attack that first and leave the car for last. That's the order that will save you the most money in interest payments.

[c3troop]

Wow disneysteve thanks alot for the very informative post. That all made alot of sense.

Quick idea of budget is we take home 5200 a month and spend roughly 3000 so we have a decent amount left each month to try to get rid of debt.

Why would you sell the rental property?

[artwest]

In my opinion, you should sell your rental. You say it is worth $130,000 and you only owe $103,000. You will pay off the $103,000 and have $27,000 left. Throw that at the jeep along with $1,000 of your EF and that will pay off the jeep and eliminate that $743 per month payment.

Then take the extra $2,000 per month that you have left over and build the EF up to around $15,000. It looks like this should take about 5 months. You can then start throwing that extra $2,000 per year at your student loans. That should be paid off in about 8 months.
In about 13 months, you would be debt free except your house and have $15,000 in a liquid EF.

The next step would be to apply that extra $2,000 to you house. It looks to me like you should be able to be completely debt free in about 5 years.

[disneysteve]

Originally Posted by c3troop

Why would you sell the rental property?

Because you had no business buying it in the first place and it isn't really making you any money. While I have nothing against owning investment real estate, that is a step that should only be taken after all of your basic financial needs are taken care of. You should have an adequate EF, be saving 15% for retirement and ideally be otherwise debt--free except your primary residence.

Some will argue with me that since the property has positive cash flow, it doesn't make sense to sell it and that's a valid opinion, too. I just don't like seeing you with as much debt as you have, limited savings and an inadequate amount going to retirement right now. I think buying the property was premature in the big picture. There will always be properties out there. Clean things up. Build a firmer foundation and then, if you want to be a landlord, you can always get back into it later. Besides, you said, "I'm not sure how much longer we are going to do the rental thing because it is stressful and ties up alot of our money." so I think you've already realized that it probably isn't the best thing for you right now.

[disneysteve]

Originally Posted by c3troop

I also have a pension that I am forced to pay in 6%. I will be leaving the government as soon as possible, so I will not be retiring with the pension.

What happens to the money you've paid in when you leave the job?

[c3troop]

Steve, when I leave I will get lump sum check.

Also, I will be recieving roughly $9,000 from overtime over the next three months. I'm thinking putting this money in a Roth?

[artwest]

I'm not Steve, but I would be throwing that $9,000 either at the debt or into the emergency fund.

[c3troop]

I want as many opinions as possible. Thanks for weighing in!

[Ima saver]

When I was much much younger, I thought rental properties were the way to go. I bought 3 houses and all 3 turned out to be nightmares! I wound up selling them all at a loss. I would suggest you sell your rental house first! Then build up your emergency fund.

[disneysteve]

Originally Posted by artwest

I'm not Steve, but I would be throwing that $9,000 either at the debt or into the emergency fund.

This is a tough one. One thing to keep in mind with Roths is that you have a limited time in which to make your contribution. You can never go back in time and catch up for years when you didn't contribute. I think that can tip the scale toward funding the Roth even if you have other debt.

I'd go ahead and put at least some of the extra money toward the Roths. Then use the rest for debt reduction. That isn't the pure answer you'll get from some, and certainly isn't what debt-guru Dave Ramsey would suggest, but I think funding a Roth when you are young is one of the greatest gifts you can give yourself.

[JustBill]

Just one line of thought about paying the student loans, albeit at a higher interest rate, before paying the lower interest loans. And not intending to be morbid. Guaranteed Federal student/stafford loans, that don't carry a co-signer, are always discharged at death. Meaning the surviving spouse doesn't have to pay the loan, and in theory the accelerated payments to the S/L would be proven non-beneficial to the living spouse. Also, should the (living) debtor of the student loan become incapacitated and not able to work, or for whatever reason that there may be a remaining unpaid balance at the end of 25 years, the debt is also discharged. The debtor is only 1099'd as income on the discharged amount. If unable to pay any due taxes, then the debtor's estate would pay the unpaid tax at death. Provided of course there are assets at death to cover, otherwise nothing is paid.

[jpg7n16]

Originally Posted by disneysteve

Some will argue with me that since the property has positive cash flow, it doesn't make sense to sell it and that's a valid opinion, too.

I think it has more of a 'it looks good on paper' version of positive cashflow.

OP stated in post 1 that all profits have been 'reinvested' (aka spent on repairs). This positive cashflow is just a phantom gain. In reality, they aren't able to keep any money they make on it (and have to pay tax on it too - you can't deduct repairs).

A lot of hassle for $0 income, seems to lean towards selling the property.

Originally Posted by JustBill

Just one line of thought about paying the student loans, albeit at a higher interest rate, before paying the lower interest loans. And not intending to be morbid. Guaranteed Federal student/stafford loans, that don't carry a co-signer, are always discharged at death. Meaning the surviving spouse doesn't have to pay the loan, and in theory the accelerated payments to the S/L would be proven non-beneficial to the living spouse. Also, should the (living) debtor of the student loan become incapacitated and not able to work, or for whatever reason that there may be a remaining unpaid balance at the end of 25 years, the debt is also discharged. The debtor is only 1099'd as income on the discharged amount. If unable to pay any due taxes, then the debtor's estate would pay the unpaid tax at death. Provided of course there are assets at death to cover, otherwise nothing is paid.

OP's family may pull in $120k this year, and the SL's are only $16k. There is hardly enough benefit in planning for the untimely death of a borrower on this student loan. There is a clear benefit to paying the SL's 1st in the event that the owner lives a long and happy life.

If you're concerned about the financial repercussions of dying early - buy life insurance.

[jpg7n16]

Originally Posted by c3troop

Steve, when I leave I will get lump sum check.

Also, I will be recieving roughly $9,000 from overtime over the next three months. I'm thinking putting this money in a Roth?

This money will be moving from a pretax pension - I'd look to roll into a traditional IRA if possible. This would avoid any tax implications today. You are trying to free up cash to eliminate debt, not pay out cash towards unnecessary taxes. Converting to a Roth would require you to pay taxes today.

When you leave your firm, you should discuss with the HR/benefits/payroll dept what your options are for rolling the money over to an IRA as opposed to taking a check for the balance.

It may be an option.

Publication 575 (2010), Pension and Annuity Income

[Frugal]

I agree that student loans should be paid down first ideally, if they have the highest interest rate. I also am stuck in a not so fun situation of trying extremely hard to pay down student loans with a 6.8% interest rate on most of them (I love how everyone thinks federally subsidized loans are so great...doesn't sound like low interest to me! We pay MUCH less interest on our house than on my stupid student loans!).

If you take the approach I did of paying off the highest interest rates first, it can really bring down the principal. I estimate I have already saved myself about $2,000-$3,000 in interest by scrimping and saving extra to pay down the principal on my highest interest rate student loans.

[esb3357]

Personally I would keep the rental house. How much "money" a month is it costing you? If you are not making any month but not losing any month then I would keep it. As long as you are breaking even you are making money because someone else is paying your mortgage. My parents have had a rental house for the last 30 years. My mom said while it has been a lot of work it will be a great retirement device. Especially for a stay at home mom.

I know I probably will be the odd one out but this is what I would do (this is what we actually are doing ourselves so I am not giving any advice I am not personally doing). I would start budgeting at one income NOW. Pay off the car the first. Than the student loans and worry about the mortgages last. I would increase your 401K to 10% and do the same with your wives and max your ROTHS. I was always taught that your retirement should ALWAYS be 10% and get use to not having it.

Half of my salary goes in to the emergency fund the other half goes into long term savings but not retirement. While no debt is good, mortgages and student loans get tax write offs. Plus what are you going to be making in the market versus what are you loan rates. I would not pay off my house at the expense of not having any other retirement. Remember having a few baskets with eggs in it is better than just on basket.