Which Debt First?

Home Money Budgets & Budgeting Answers Which Debt First?

I have a 30-year loan on my townhouse with 7% interest. I paid $75,500 and three years later I owe $73,000. My only other debt is a 6-year new car loan with 12.6% interest. I paid $23,770 and have not made my first payment yet. If I have extra money each month to pay towards one of these debts, say $400, which one should it go to? Things to factor in: property values seem to have dropped the value of my house by about $10,000. I might live there forever but I might sell it in a couple of years even if I take a loss. What is the best thing for me to do and how much money would it save? I tried to calculate everything but ended up over my head with numbers. I am only 27 and have money currently going into retirement and investments. I want to get all of my debt paid off.
Christine K.

Christine asks a good question. When there's some extra money at the end of the month, which debt should be paid off first. When you start to factor in home prices and possible moves, it can be confusing.

There's probably no one universal 'right' answer. With this type of question you can always come up with some unlikely situation that would favor one answer over another. We'll deal with the possibilities that are most likely to occur.

Let's take a look at the home mortgage. With a 30 year, 7% mortgage, Christine will be paying off between $60 and $70 principal each month. As time goes on the interest payment drops and the amount applied to principal increases a little. With 27 years to go on the mortgage she won't have a mortgage burning party until 2028. And she would have paid over $105,000 in interest over the whole life of the loan. So she'll make $180,000 in payments to pay for her $75,000 home.

What happens if she puts that $400 each month towards the mortgage. She'll have the mortgage paid off much sooner. In fact, it will only take ten years to have her home free and clear. And she'll reduce her interest expense to only $28,000. A significant difference.

Next, let's look at the car loan. As Christine said, it's a 6 year loan. Payments should be about $475 each month. Of that, about $225 is going to principal now. And, just like the home mortgage, each month a little more of her payment goes to reduce the loan balance.

If she doesn't prepay the loan she'll pay a total of $10,000 in interest. So the car will actually cost her a little less than $34,000. If Christine adds $400 to each car payment, she'll have the loan paid off in less than 3 years and reduce the amount of interest paid to $4,400.

So which is the better deal? Under most common circumstances she'll come out ahead by paying off the loan with the highest interest rate first. How do we know? Let's create a test. We'll see what Christine's debts will look like in two years under each strategy.

Begin with a scenario where she doesn't prepay anything. In two years she'll still owe $17,730 on her car and $73,910 on her home. Or a total of $91,640 in debts.

Now, let's suppose she used the $400 each month to prepay her mortgage. In that case two years from now she still owe $17,730 on her car. But her mortgage balance would be reduced to $63,638. So the total owed would be $81,368.

OK, so what happens if she applies the extra $400 to her car note? Then she'd still owe $73,910 on her home, but her auto loan would show a balance of $6,877 for a total debt of $80,787.

So she's $581 ahead by putting the extra money on her car loan. The longer she does that the bigger the difference.

There's one other advantage to paying off the car loan first. If she doesn't prepay it she'll almost certainly be 'upside down' in the car for years to come. So if she needed to sell it in a couple of years she'd actually have to pay to get someone to take over her payments.

What happens if Christine sells her home in a couple of years? Or if it's value decreases? Most likely, nothing. The only time she would have a problem is if she wanted to sell the home and it's value was less than the balance of her mortgage. And while that's possible, it's not too probable. Especially if her down payment was 10% or more.

But doesn't she lose the advantage of prepaying if she sells? No. When she sells her home she'll have to pay off the mortgage. So any prepayments that reduce the balance of the mortgage will increase the size of the check she would get when she sells. So she wouldn't lose anything.

One warning for Christine or anyone else making principal repayments. Make sure that any prepayment is applied to principal. Some lenders have a nasty tendency of applying extra money to your next month's payment. And that will drastically reduce the effectiveness of any prepayment.

A final comment. The same process could be used if Christine had credit card debts. Barring really unusual circumstances, it's always best to pay off the highest interest debt first.

Gary Foreman is a former financial planner and purchasing manager who currently edits The Dollar Stretcher.com website and newsletters. He's been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report and he's a regular contributor to US News Money and CreditCards.com. You can follow Gary on Twitter or visit Gary Foreman on Google+.

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