I have a question. I recently started working after finishing grad school & wanted to pay off some money toward my student loans.
I currently have 2 loans oustanding
1) Car loan ~$13,000 at 5.49% interest rate.
2) Student loan ~$38,000 at 3.875% interest rate.
Which one of these should I work toward paying off first? I was thinking it was better to pay the one with the higher principal rate down first (the student loan), but a friend thought differently...and maintained I should pay off the higher interest rate regardless of principal.
In general, it is better to pay off the loan with the highest rate first, but there are exceptions.
For example, if you can't be assured of having enough income to cover the minimum payments on both loans through the end of the shorter loan's term, you may want to pay off the shorter one first even if it has a lower rate.
As another example, there is a lot to be said in favor of building up a cash cushion before you make accelerated payoffs on everything, especially if the interest rates on the loans are relatively low.
But in general, you will be better off paying off high-interest loans first.
Car loan. It has both the higher rate and smaller balance, so when you do pay it off, you can start paying off the student loan faster instead.
But.... both of those loans are pretty low-interest, so I don't see any particular rush to pay them off except on the general principle of getting/staying out of debt. In particular, if you're not already doing these things, it might make more sense for you to start setting money aside in an emergency fund, putting enough in your employer's
401(k) plan to get the full company match, and possibly funding a Roth IRA each year, too.
I'm just a beginner at this stuff myself, but here is my thinking...
Let's say you can put an extra $1,000 over and above the minimum payments on one of the loans to help pay it off. Which would save you the most money? Well if you put the thousand on the car loan, you will save $54.90 times the number of years left on the loan. If you put the thousand on the student loan you will save $38.75 times the number of years left on it. So how many years are left on each?
The car loan. Not only is your student loan at a lower interest rate, but the interest is potentially tax deductible. You can deduct the interest on your student loans regardless of whether or not you itemize. However, if your adjusted gross income is too high, the deduction is phased out. For 2006, the phase out begins at $50K for single filers, $105K for married filers.
The deduction has the effect of essentially lowering your interest rate by the amount of your tax bracket. For example, if you're in the
25% tax bracket, the effective interest rate on your student loan is (1-25%)*3.875% = 2.9%. That's pretty close to the rate of inflation (less, actually). So there's really no reason to accelerate repayment of the loan - it'll actually cost you more.
I agree with what others have said about focusing on building up savings, first. I would much rather have a 5.49% loan and a healthy savings than no loan and no savings. Why? Because unexpected things happen. As a prime example, I offer my own family. My wife and I have been working through our county to adopt a baby. We got the call two days ago that we're bringing home a baby boy, today (thanks for the advance warning!). Without a few months' worth of living expenses in savings, I don't know how we'd be able to pull this off. But because we have the cushion, we can both take off from work and not have to worry about money for at least a few months.
Let's take a different tact. Pay off by transfer to a credit card the student loan.
In the event you get layed-off or disabled your bankruptcy will eliminate the unsecured loan (student).
I have a client with 100k in student loans and no visible means to ever pay it off. Student loan system should never give these huge loans to students in majors where salaries are so low they will never pay them off.
I would agree with the above statement. Although I currently have a $5000 car loan at 2.99% myself, it's nice knowing that I have an emergency fund sources of funds. I could use one of these funds to pay for the car now but then I would lose of on my savings funds and then have to work to get one of those funds back up.
If an major emergency were to arise then I would have to take funds out of a retirement plan and that's costly tax wise and retirement plan wise.
I know I sleep much better at night paying a smaller interest car loan and having emergency savings stashed away then having a paid off car and a lower emergency fun
That logic will produce flawed results. It would suggest that a 30 yr loan at 4.5% should be repaid faster than a 12% credit card that has a 5 year payback. If this is the only choice, pay 1 or 2 faster, I'd choose the higher rate (ignoring the number of years left) which is the 5.49% note.
But, as others posted, I'd first ask; Does OP have a matching 401(k)? Is she funding up to that match? Roth IRA? Then, how is the emergency fund? While it's a great feeling to knock down debt, both lending institutions are not likely to re-lend her the money at the same rate. It appears the message that "debt is evil" has been well broadcast, but in my 'hierarchy of money priorities' the fast payoff of this debt isn't at the top.
And in the event that you don't declare bankruptcy (or you do declare it but your income is high enough), not only does the credit card debt not go away, but it's going to be at a much higher interest rate.
This is seriously flawed advice. Do NOT do this.
If you are on the verge of bankruptcy, you need to talk to a lawyer, not this newsgroup.
And if you are not on the verge of bankruptcy, there's no upside to this advice.
I know Elle will berate me for posting here while I should be attending my foster son (though to be fair, he is sitting right next to me). But when I read this, I just had to chime in.
Bread is absolutely right. The above is seriously flawed advice. Transferring your student debt to a credit card will A) SUBSTANTIALLY increase your interest rate and B) eliminate any possibility of deducting the interest. That's a steep price to pay for having the debt discharged if you have to claim bankruptcy. Claiming bankruptcy is truly a last resort. God-willing, you'll never be in that situation.
Why? I'm just learning here. It seems to me that if putting a $1,000 on one loan would save me $275 (assuming loan 1 is 5 years) and putting a $1,000 on the other would save me $387 (assuming loan 2 is 10 years) then I should put the money on the one that saves me the most...
I know it *looks* like by multiplying by the number of years remaining, you are taking time-value of money into account, but you are not. In order for it to (better, but not perfectly) do so, you need the same time periods. Look at it this way:
Let's look at two debts and I'm going to make up some easier number - suppose you have a 5 yr loan at 5% and a 10 yr loan at 3%. The sizes of the loans isn't important for the moment, but we're going to assume you have $1000 in hand available to pay one of them down. According to your method, paying that $1000 on the 5yr loan will save you $50/yr for 5 yrs = $250 and on the 10 yr loan, it'd be $30/yr for 10 yrs = $300.
The thing you're ignoring is that second 5 years - by paying down the 10 yr loan, not only are you not paying the $150 in interest in the first 5 years, but you are not paying the $150 in interest during the second 5 years. With the
5 yr loan, you are not paying $250 during those first 5 years, but your *also* not paying any interest during those second 5 years *either*. You cannot ignore that. So you need to either assume that had you not paid off that first loan, then after 5 years, you'd have had to refinance it or borrow again and pay some interest - who knows what - during that second 5 years. Or you have to ignore that second five years for both the first and the second loan - in which case, your choice isn't $250 for one or $300 for the other, but, indeed, saving $250 for one or $150 for the other.
In other words, if you compare interest over time, you need to match the time periods one way or another. An interest rate is a *rate* - an amount *per year*. So you have to compare over the same number of years.
There may be other considerations (ie. cashflow, minimum payments, liquidity, etc) but all else being equal, it's generally going to benefit you more to pay off the highest rate first, at least in simple dollar terms. Not the longest, not the highest balance, but the highest rate.
It would not. A 12% credit card versus a 4.5% loan means you are paying more interest over any identical time period. During year on, $1000 loan at 12% means you are paying $120 to someone, versus paying $45 to someone. At the end of year one, regardless of the term remaining on the loan, you have less money if you pay the higher rate.
There may be other considerations - generally cashflow-related ones (ie. size of minimum payment, etc) - but in general, if you want to keep more of your money, pay the highest rate loan off first.
Because what counts is how much interest you've paid on your year end statement. It's actually simpler than you are trying to make it. $1000 on the mort, costs $45/yr, on the CC $120. (For this exercise, let's ignore the tax implications, but in many postings I won't). Since I'm looking at the cost per $1000, and focusing on the rate itself, neither the total loan nor the time left on the loan come in to the decision. In fact, with the rate on the mortgage below current money market rates, one would not pre-pay this at all, just build cash on the side earning more than the cost of the money.
Consider this absurd analogy - I lend you $1000, at 2% interest, the term is 100 years, in 2107 the $1000 is due, and just the $20/yr until then. Applying your time equation, you'd consider paying this off sooner than the credit card debt, so long as the ($1000 x int x time) was over $2000.
In all fairness, there are those who have a bit of a different take on this such as Dave Ramsey, see
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for my analysis of his approach, to choose the smaller debt first. We also have a friendly debate here whether to invest in the stock market vs paying down one's mortgage faster. I'm on the fence there, and still considering both sides.JOE
But ignoring feelings and looking at numbers, says to pay off the higher rate first.
Not everyone does that well with that. Neither can everyone maintain the discipline to pay off his credit card each month, either. Some folks can and some can't. For those who can't, they need to take their own behavior and motivation into account and recognize these things and find ways to help themselves stay the course. If that means using a debit card instead of a credit card, or paying off the smaller loan rather than the higher rate loan, so bet it.
Understood. Which is why I referenced that, acknowledging that it's not all about the numbers. And why the 'sleep factor' can produce a different plan for two individuals whose numbers are precisely the same. In this case, so long as Daniel understands the numbers, he is free to choose his path. JOE
But of course, shortening the duration of a loan is going to cost less.
I guess the part I'm having trouble with is this: The cost of the loan is dependent on (1) the APR and (2) how long you are borrowing the money for. To not take the latter into account seems wrong to me somehow.
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Your first example had a different $$ amount, so I snipped it. Above we are left with a total of $19,000 and you have a total paid which indicates you favor borrowing more money at 5% than 3%. As a snapshot, 9K @ 5% = $450 interest, + $10K @ 3% = $300 interest, total $750. Second numbers, $10K @5% = $500 + $9K @ 3% = $270 total $770 interest.
One can easily contrive a series of low dollar, high interest, short payback loans that appear to have less interest than a higher dollar, long term low interest loan. That's why the math is wrong, as BWS tried to help me explain, you need to take a snapshot of 'annual interest cost per thousand' to compare the choices. The difference above, 5% vs 3% will produce a tiny difference, $20/yr. But if you apply this logic and one day decide to pay down your 6% mortgage but leave a 20% credit card chugging along, I'd hop on a soapbox to save you from your misapplied equations. Take some time to think on this.
You are using *payments* not *interest* to compare. Much of those payments is principal and by munging it, you are, again, mixing up a comparison of apples and oranges. Of course you pay more over time when you borrow longer. But if you took that 10yr at 3% and made payments at the same total quantity as the 5% loan, each payment would have an even greater proportion of principal than the 5% loan and, in fact, you'd pay off the 10yr 3% loan in *less* - substantially less time than that 5% loan.
Flip it the other way around, if you took that 5yr loan and only paid the 10yr payment, since you'd be underpaying on the principal, you'd not have it paid off after 5 yrs and you'd have to keep paying for quite a while after that.
You are getting confused because you are mixing up principal and interest. The numbers are easier to compare if you do it in non-amortizing (ie. interest-only) space.
Be careful using the word 'duration'. We know what you mean, but to bond people, 'duration' has a very specific meaning quite different from 'maturity'.
There is a third variable here that is important to understanding some of the others' points about paying off the higher APR first, regardless of term: (3) what one would make if one invested in say a CD instead of paying off the lower interest, but longer term, loan.
A concept called the "future value of money" is one with which you need to become familiar.
All other things equal, paying off the higher interest rate loan first will benefit a person more, regardless of the time period of each loan.
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