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Multiple Loans - Paying additional principle


myhousekey
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Hypothetical example of the situation:

 

Loan #1 (Student Loan) - 3% fixed rate. 15 year loan. $15,000 principal.

Loan #2 (Auto) - 4% fixed rate. 5 year loan. $20,000 principal.

Loan #3 (Home) - 6% fixed rate. 30 year loan. $150,000 principal.

Loan #4 (Home #2) - 7% fixed rate. 15 year loan. $25,000 principal.

 

You are currently making the minimum payment on all four loans that will allow you to pay off the loan completely by the end of the loan term.

 

You have $100 extra a month you would like to apply toward the principal of one of the loans. How do you decide which loan's principal to apply the extra $100 to? What makes the most economical sense?

 

My first thought was you would pay the loan with the highest interest rate. However, you'd save on the most interest by paying on the loan that is the longest in length.

 

I believe the answer lies somewhere in between as a combination of interest rate and length of loan but I can't seem to get a good grip around quantifying the answer thru calculations.

 

Thoughts?

Edited by myhousekey
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Assuming you itemize your deductions, you can deduct the interest expense for the mortgage and the student loan (subject to some limitations I believe). The mortgage effective rate falls somewhere close to the 4% you are paying on you car. The student loan effective rate is already the lowest and tax deductible.

 

Given that cars depreciate in value and the effective rate is close on the house, I would send the extra payment to the car.

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Puddy. Thanks for the reply. Sounds like you have to look at it situation by situation. I didn't want to put my exact siutation up so I just created an example, figuring there was some mathematical analysis that could be done. I totally forgot to take into account tax deductions.

 

Also just realized I have a loan with the largest interest and longest term in my example. That wasn't my intention...fixed.

Edited by myhousekey
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Pay the extra payment to the loan that has the highest ratio of "Minimum Payment" to "Remaining Balance" ... this is your most expensive "cash flow loan".

 

X = (MinPmt / Balance)

 

After you pay of the most expensive cash flow loan, you will free up proportionally more cash to pay of the next most expensive cash flow loan.

 

Note, this really only works if there is one or two loans that are meaningfully more expensive from a cash flow perspective than the others ... otherwise, I'd simply pay the extra cash towards a loan that had the highest after-tax rate (which may not be the right answer, although it's what I'd probably do).

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I say instead of adding an extra 100 to a balance of one of your bills, start a Roth Ira with the money. House loans have tax savings, student loan interest is so small and the car you will [probably trade in a couple of years anyways. Note if you already have a Roth, college fund for kids(if you have kids) or mutual funds.

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Assuming you itemize your deductions, you can deduct the interest expense for the mortgage and the student loan (subject to some limitations I believe).  The mortgage effective rate falls somewhere close to the 4% you are paying on you car.  The student loan effective rate is already the lowest and tax deductible.

 

Given that cars depreciate in value and the effective rate is close on the house, I would send the extra payment to the car.

 

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I agree. Non-tax deductible consumer debt is the first thing you want to get off your back. Plus, with only a $20,000 principal balance, if you hit that one hard for a couple years you'll pay it off early and free up cash flow on a go-forward basis.

 

Investing the extra money is also an alterative to consider. You'd need to feel secure that you can find an investment that would produce an after-tax ROI in excess of 4% - and be highly liquid in the event that you need access to it - over the next few years. If that sounds like too much work, or you just want to take the bird in the hand, paying down the car note is the best thing to do. However, if you think you can get over 4% ROI after tax, invest the money in the short term, then apply it all to the balance of the car note as soon as it equals the outstanding principal balance on the loan. Depending on how much better than 4% your rate of return was, you might end up paying the note off a little faster, though probably not by a whole lot. The risk-free route is just to over pay the car note each month, though.

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I put the extra money towards the car payment. Don't know if that's what I should've done but it's what I did and now I have no car payment. Well, until I give my current 2nd car to the kid turning 16 and have to buy another one for myself to drive.

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I put the extra money towards the car payment. Don't know if that's what I should've done but it's what I did and now I have no car payment. Well, until I give my current 2nd car to the kid turning 16 and have to buy another one for myself to drive.

 

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That's my fear as well. As soon as I pay off the first car I'll end up with another one soon enough.

 

Here's what I ended up doing.

 

Using a loan calculator I determined the following:

 

1. Total $ Savings on each loan if I would apply the extra $100 in principal a month to it.

Student Loan = $1952

Auto = $88 (this surprised me)

Home 1 = $44,945

Home 2 = $7003

 

2. Total savings on the # of payments (time) on each loan if I would apply the extra $100 in principal a month to it.

Student Loan = 98 fewer payments

Auto = 13 fewer payments

Home 1 = 81 fewer payments

Home 2 = 77 fewer payments

 

Then using those totals, I calculated the following:

1. % of Money saved with respect to each loan.

Student Loan = 10.5% savings

Auto = 0.4% savings

Home 1 = 13.9% savings

Home 2 = 17.3% savings

 

2. % of Payments (time) saved with respect to each loan.

Student Loan = 54.4% savings

Auto = 21.67% savings

Home 1 = 22.5% savings

Home 2 = 42.78% savings

 

Looking at those percentages I determined it would be best to pay off Home Loan 2 first as it has the highest % of money saved and the 2nd highest % of time saved.

 

I'm not even sure if my thought process behind this is at all legitimate and I'm definitely not taking into account the ability to deduct the home loans interest on my taxes but I figured it was a start. :D

 

Thoughts?

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i'd put it toward the 2nd mortgage (as it seems you have). simply put, it's the highest interest rate. that's the only number that really matters. the tax ramifications change that a little bit, but by doign this you really don't start running into less mortgage interest to deduct until a few years down the road. AND you get to 20% equity in your house a bit faster, when you can re-fi into one loan with a much lower rate.

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