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Which Debt First?

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 there’s some extra money at the end of the month, which debt should be paid off first?

According to Gary Foreman, editor of The Dollar Stretcher, there’s 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. Let’s look at the possibilities that are most likely to occur.

First, 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 won’t 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.

What 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 you’ll reduce your interest expense to only $28,000; a significant difference.

Next, let’s 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.

If you don’t 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, you’ll come out ahead by paying off the loan with the highest interest rate first. How do we know? Let’s create a test to see what your debts will look like in two years under each strategy.

Begin with a scenario where you don’t prepay anything. In two years, you’ll still owe $17,730 on the car and $73,910 on your home, a total of $91,640 in debt.

Now, let’s 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.

What happens if you apply the extra $400 to your car note? You’d still owe $73,910 on your home, but the auto loan would show a balance of $6,877, for a total debt of $80,787.

So, you’re $581 ahead by putting the extra money on the car loan. The longer you do that, the bigger the difference.

There’s one other advantage to paying off the car loan first. If you don’t 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, you’d actually have to pay to get someone to take over your payments.

What happens 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 that’s possible, it’s not too probable, especially if your down payment was 10 percent or more.

And, you don’t 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.

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