Pay down student loan, mortgage or car?

[brittq]

Hello, I am looking for some advice on what would be the best use of ~$10,000 out of the following debts:

I have a $210,000 mortgage at 4.875% and currently paying $100 a month in mortgage insurance premium which will go away when I bring the mortgage amount to $200,000. My last mortgage payment was broken down like so: Interest $854, Principal $305, Escrow $700.

$40,000 in student loans at 6.5%, currently 10 year term.

$90,000 wife's student loans at 6.5% currently at 25 year term.

$25k car loan @ 2% and 5 year term.

Please let me know if any other information is needed to help.

Thank you.

[BMEPhDinCO]

What are your monthly payments on the student loans? Are those SL rates fixed or variable? Can you look into consolidating them?

Don't pay off the car loan.

The math points to the $90k loan - it's the highest rate and the highest amount at that rate. However, if you could save $1,200 a year by paying down the house to $200k, that could also be useful and then put that amount towards the $90k loan.

[brittq]

Thank you for the response BMEPhDinCo,

The student loan rates are fixed. I pay $500 a month on mine, the first payment on my wife's student loans start next month and I think are ~$600 (I'll have to check).

With no additional payments to my mortgage I would reach $200,000 around June 2015, so that would comes to $2,800 of mortgage insurance payments.

I guess I am not sure how to determine which is more beneficial.

Saving $2,800 over the next couple years and increasing the equity in my house w/ a 4.875% interest rate. Which would save ~26,000 in interest over the life of the loan. We plan on moving in a few years, if that changes anything.

or

Putting $10,000 down on the student loan which should save ~ $30,000 in interest over the life of the loan.

[bjl584]

It may be better to invest the $10,000 and not put it toward your debts. How old are you? How many assets do you have? Are you on track so far as retirement is concerned? If your debts are manageable, then it may be better to invest the money.

[brittq]

I am 27 years old.
$40,000 equity in my house.
$43,000 401k.
$3,000 Roth IRA.
I make $100,000 a year, wife will start working next month and will make ~$35,000.
keep $5,000-$10,000 cash in checking.
Credit score 780.

No credit card debt.
$130,000 student loans 6.5%, $1,100 a month
$210,000 mortgage 4.875%, $1,850 a month (includes PMI, insurance, tax, etc)
$25,000 car loan 2%, $450 a month

[lindsay06]

I've always been told to pay down the mortgage first so that would be my advice.

[easystudent]

Reduce interest rates if possible
Make more frequent (or bigger) payments
Earn more income to put toward loans
Budget better and save money

[Jerry91]

It will be better to pay off your mortgage in full as it will help to make your home free and clear.

[smk]

the calculations are relatively simple. put the payments net of tax savings for each loan in a spreadsheet. add all the payments up. then calculate the npv (net present value) of the whole series of payments. then try paying down each debt and adjusting the series of payments to reflect the new balance. go with whichever produces the lowest npv. you might also consider refinancing your mortgage if it is possible. financial institutions that speculate on markets by investing the money in stocks tend to be closed down by regulatory authorities for lack of safety and soundness...

[cschin4]

I live "contrary to the advice". As a result, i have crossed the $1M threshold in my retirement accounts, have 2 fully paid off cars, no debt and my home is paid off!

In my opinion, paying off your home is the BEST use of your resources. You should OWN the thing that has value! The other things like a car depreciate and are worth diddly. Why rush to pay those off? Finance those because you are basically renting out their value anyway and they aren't worth anything. That is where i would concentrate and let the others ride.
But, in the future, dont' buy such an expensive car.

[auron]

Pay down the mortgage! Saving $100/mo on PMI for 2 years is approx ~12% ROI and increases your home's equity for when you decide to move.

You already have a job with the skills earned with the SL - paying this early with the other debts will not significantly change your financial position.

Same line of reasoning for the car. You need it, but paying early doesn't gain you much besides saving interest.

[dczech09]

I am not so sure that I would put the $10k towards the mortgage. I am not saying "don't." I am just saying I am not sure.

Eliminating PMI would be great and frees up $100 per month in cash flow. The problem is that you do not know how the housing market is going to work out in the near future. The houses value could drop and you could end up below the 20% equity threshold again.

IMO, you should never have bought the house with less than 20% equity position, but that is just my humble opinion and hindsight is always 20/20. Actually you probably should not have bought the house with over $100k in student loans But what is done is done. I am not judging.

I will lay out three methods and you can choose to do as you wish.

Snowball-
Dave Ramsey's snowball method would tell you to list the debts smallest to largest and attack the smallest first. In this case, the auto loan would be best. Then attack the student loans, and finally the mortgage.

Avalanche-
List your debts highest interest rate to lowest and attack the highest first. Your student loans would be the targets. It does not matter that you have $40k and your wife has $100k. The fact of the matter is that you have $130k at 6.5%. Whichever one of the two you attack, you will net the same benefit. After the student loans, attack the mortgage, then finally the auto loan.

Hierarchy-
This is my method that I created. Your auto loan is inherently the riskiest of all of your debts. Sure, it has the lower interest rate. But it is losing value as well. And because of that loss in value, you run a HUGE risk of becoming "underwater." If you become underwater, you are stuck in a jam which makes the situation even more risky. Since it is so risky, we must factor that into our decision making. We cannot necessarily quantify the risk, but we can say "hey, this makes the auto loan more expensive than the other two, all things considered." So I would attack the auto loan first and foremost. Then attack the student loans, and finally the mortgage.

I hope this helps!

[smk]

Snowball-
Dave Ramsey's snowball method would tell you to list the debts smallest to largest and attack the smallest first. In this case, the auto loan would be best. Then attack the student loans, and finally the mortgage.

Avalanche-
List your debts highest interest rate to lowest and attack the highest first. Your student loans would be the targets. It does not matter that you have $40k and your wife has $100k. The fact of the matter is that you have $130k at 6.5%. Whichever one of the two you attack, you will net the same benefit. After the student loans, attack the mortgage, then finally the auto loan.

Hierarchy-
This is my method that I created. Your auto loan is inherently the riskiest of all of your debts. Sure, it has the lower interest rate. But it is losing value as well. And because of that loss in value, you run a HUGE risk of becoming "underwater." If you become underwater, you are stuck in a jam which makes the situation even more risky. Since it is so risky, we must factor that into our decision making. We cannot necessarily quantify the risk, but we can say "hey, this makes the auto loan more expensive than the other two, all things considered." So I would attack the auto loan first and foremost. Then attack the student loans, and finally the mortgage.

I hope this helps!

generally I like dave ramsey, but the size of the loan is not really an issue in most cases. only if you want collateral unencumbered so you can take out a new loan. just getting things unencumbered will only make you feel better, not necessarily lower your overall debt.

for the highest rate, that makes sense, but the term of the loan should be considered. that is why the greatest impact on npv is the standard method in finance.

as for hierarchy, that does not make a lot of sense. you owe the money irrespective of whether the collateral is underwater or not. if it is underwater, the risk is to the bank and not to you. why would you pay off a lower rate loan because you are worried it might go underwater? you are increasing your overall amount of debt...

[dczech09]

generally I like dave ramsey, but the size of the loan is not really an issue in most cases. only if you want collateral unencumbered so you can take out a new loan. just getting things unencumbered will only make you feel better, not necessarily lower your overall debt.

for the highest rate, that makes sense, but the term of the loan should be considered. that is why the greatest impact on npv is the standard method in finance.

as for hierarchy, that does not make a lot of sense. you owe the money irrespective of whether the collateral is underwater or not. if it is underwater, the risk is to the bank and not to you. why would you pay off a lower rate loan because you are worried it might go underwater? you are increasing your overall amount of debt...

I agree that the size of the debt is usually not that large of a factor. But to someone who may need quick wins to keep them motivated, the debt snowball method serves well.

Nobody does NPV analysis on debt. If they did, they probably would have not went into debt in the first place. So I am not so sure that NPV is really going to be a relatable topic for someone who did not study finance like you or I.

I am not sure I follow you when you say "you are increasing your overall amount of debt..." When I mention any of the above methods, I mean make the minimums on all debts, but put the rest of your focus on whatever debt is selected based on the methodology.

And becoming underwater on your car is a HUGE risk to you, not just the bank. If you become underwater, you are stuck with the car. Try selling a car when you're underwater with it. The risk is absolutely on the borrower. So yes, we have to factor this into our decision making. My hierarchy applies this with car loans and such (not mortgages) because the collateral is likely going down in value. When paying off a car loan, you want to keep the loan value under the car value as best as possible. If you become underwater, then hit an emergency, the emergency will essentially be magnified.

[smk]

increasing debt levels simply means this: if I pay down a 1% loan and leave outstanding a 15% loan, in 1 year I will owe more $ than if I did the reverse.

it is true that most people do not know how to do npv analysis. perhaps if they did they not go into debt, although some people really have no choice. doesn't that tell you that if they were educated on npv analysis, there would be fewer people with debt problems? why not educate them. it is actually quite simple to do in a spreadsheet.

as for the loss of flexibility on selling a car, granted there may be issues there. but someone in debt is probably better holding the current car rather than splurging on a new one. that would be their primary limitation. selling a car in an emergency may not be a feasible response, as you will still need a car to get to work and buy food. when the car is no longer functional, you simply talk to the lender, because they have no choice at that point. HOWEVER, the money you saved by paying down more expensive credit can be applied to pay back the car loan. the main risk at that point is that you might not be able to get a new car loan or lease a vehicle.

I can see looking at an auto loan underwater as a concern that you may not be able to take out another loan if you can't keep up with the payments and the car dies before the loan matures. But I think lenders know enough to structure loans to avoid this problem and it is probably quite rare. for this rare benefit, I don't see giving up the lower debt levels overall that come from paying down higher rate loans.

the only exception to npv analysis to me would be student loans that are not eliminated in a bankruptcy and where bankruptcy is a significant possibility...