You are 27 years old and have
a 30-year loan on a townhouse with 7 percent interest, for which you paid $75,500
and three years later, owe $73,000. Your only other debt is a six-year new car
loan for $23,770. You just got a raise and now have an extra $400. You currently
have money going into retirement and investments. When theres some extra
money at the end of the month, which debt should be paid off first?
to Gary Foreman, editor of The Dollar Stretcher www.stretcher.com, theres
probably no one right answer. With this type of question you can always come up
with some unlikely situation that would favor one answer over another. Lets
look at the possibilities that are most likely to occur.
the mortgage. With a 30-year, 7 percent mortgage, you will be paying off between
$60 and $70 in 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, you wont have a mortgage-burning party until 2028. And, you
would have paid over $105,000 in interest over the whole life of the loan. So
you will make $180,000 in payments to pay for your $75,000 townhouse.
happens if you put that $400 each month towards the mortgage? You will have the
mortgage paid off much sooner. In fact, it will only take 10 years to have your
home free and clear. And youll reduce your interest expense to only $28,000;
a significant difference.
Next, lets look at the car
loan. With a six-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 your payment goes to reduce the loan balance.
you dont prepay the loan, you will pay a total of $10,000 in interest. So
the car will actually cost you a little less than $34,000. Add $400 to each car
payment and you will have the loan paid off in less than three years and reduce
the amount of interest paid to $4,400.
So which is the better
deal? Under most common circumstances, youll come out ahead by paying off
the loan with the highest interest rate first. How do we know? Lets create
a test to see what your debts will look like in two years under each strategy.
with a scenario where you dont prepay anything. In two years, youll
still owe $17,730 on the car and $73,910 on your home, a total of $91,640 in debt.
lets suppose you used the $400 each month to prepay the mortgage. In that
case, two years from now you still owe $17,730 on the car. But your mortgage balance
would be reduced to $63,638. So the total owed would be $81,368.
happens if you apply the extra $400 to your car note? Youd still owe $73,910
on your home, but the auto loan would show a balance of $6,877, for a total debt
So, youre $581 ahead by putting the extra
money on the car loan. The longer you do that, the bigger the difference.
one other advantage to paying off the car loan first. If you dont prepay
it, you will almost certainly be "upside down" in the car for years
to come. If you needed to sell it in a couple of years, youd actually have
to pay to get someone to take over your payments.
if you sell your home in a couple of years, or its value decreases? Most likely,
nothing. The only time you would have a problem is if you wanted to sell the home
and its value was less than the balance of your mortgage. And while thats
possible, its not too probable, especially if your down payment was 10 percent
And, you dont want to lose the advantage of
prepaying if you sell. When you sell your home, you will have to pay off the mortgage.
So any prepayments that reduce the balance of the mortgage will increase the size
of the check you would get when you sell.