When it comes to debt like credit cards and other high-interest loans, these are no-brainers! Pay them off as soon as possible so you don’t spend the rest of your life paying for the growing interest on them.
Whenever I think about my own debt situation, there are always two major ones that come to mind: My auto loan and my mortgage.
Although they seem similar, these two can be somewhat tricky to compare. Paying one off before the other can have profound implications on the amount of interest you’ll ultimately pay, the number of years you’ll be scheduled to make payments, and a variety of other considerations.
Suppose you just received a pretty sizeable amount of money. Congratulations! But now what should you do with it? Here is our decision to make:
1. Do you pay down the principle of your auto loan? – or –
2. Do you pay down the principle of your mortgage?
Let’s Begin With the Facts
To begin, we’ll use some real data from my two loans:
• Remaining Balance: No surprise here. As you can imagine, I still owe much more on my house than I do my car.
• Normal Monthly Payment: This is exactly how much I pay each month. For my mortgage, I have excluded escrow (PMI, taxes, and insurance).
• Interest Rate: Both loans have a fixed interest rate.
• Original Terms (Years): The original number of years the loan was set up for.
• Years Remaining: The number of years we actually still have to make payments.
• Interest Remaining: This is the amount of money we still have to pay for JUST the interest if we were to continue to pay our monthly payments according to the remaining schedule.
The easiest way to illustrate this example is if we pretend we’re going to payoff the auto loan altogether. Therefore:
• We’ll say I have exactly $20,069.43 that I can decide to use for either loan.
For simplicity, let’s ignore any “Payoff” costs that are usually associated with completely paying off large loans such as this (like calculated daily interest, fees, etc.). Also, we will ignore property taxes, insurance, and PMI.
Apply the Math
For each situation, I will be using Microsoft Excel to perform all my calculations. There will be a link to my worksheet at the end of this example.
• Auto Loan: The math here is pretty simple. If I pay off my auto loan in full, I will stop making payments altogether. Therefore, I’d save on all the interest I would have spent had I just continued to make payments ($2,021.73). Also by doing so, I erase 4.08 years of payments which equals $450.84 x 12 months x 4.08 years = $22,091.16.
• Mortgage: The math here is a little more complicated. I already know I have 21.3 years to go and $102,787.76 in interest to pay if I just keep making my regularly scheduled mortgage payments. Now if I apply $20,069.43 (my regularly scheduled principle payment of $279.34 plus my extra-big payment of $20,069.43) to my next mortgage payment, some dramatic things happen. The number of years I have to keep making mortgage payments drops to 16.08 and the total interest I still have yet to pay on this loan also drops to $63,758.19. That erases 5.14 years of mortgage payments and $38,360.90 of interest! 5.14 years of payments gone equals $948.01 x 12 months x 5.14 years = $58,430.08 in future savings.
Summarizing all this information:
And the Winner Is?
With nearly 19 times more money in interest savings and 2.6 times more money saved in payments erased, I declare paying my mortgage down earlier to be the winner.
Keep in mind that there were infinite combinations of variables we could have put together which may have lead to a different outcome. Had the loan amounts, number of years, interest rates, amount available to payoff the loan, or anything else been different, we may have declared a different winner.
Other Considerations (Outside the Numbers)
• Depreciating Asset – In general, most financial advisers agree that you should payoff your most depreciating asset first. This is because if you can get into situation where you are “upside down” – you still owe more on the loan than what the thing you bought is worth. Between the house and the car, this is usually the car which loses value quicker. However, in the past decade, home values have dropped dramatically prompting many to question if it is any better of any investment than the car. My personal opinion: The car still depreciates faster. Therefore, the auto loan would win.
• Priority – If I did payoff my mortgage first, I wouldn’t reap any of the benefits for another 16.08 years. Essentially, I would just continue to make my payments and feel no difference in the here and now. However, with the auto loan, I would have immediately stopped making payments and had an extra $450.84 in my pocket each month that I would immediately get to enjoy. If I was in a situation where I needed the money right away, then the auto loan would be the winner.
• Tax Implications – Mortgage interest is tax deductible whereas auto loan interest is not. Therefore, between the two if I had to continue making payments on one, I’d stick with the mortgage and try to get rid of the auto loan since it doesn’t help my tax situation. Again, the auto loan is the winner.
• PMI – If you’re paying PMI each month on your mortgage, then you know that this is extra money out of your pocket each month that goes towards nothing to benefit you. In this case, paying down the principle on your mortgage would help to get your loan-to-value (LTV) ratio at 80% or lower. This would help you to get rid of PMI. Once the PMI is gone, that is more money back in your pocket each month. The Mortgage is the winner.
Show Your Work
For anyone who would like to double-check my calculations or try this out for themselves, here is a copy of the Microsoft Excel worksheet I created:
So what do you think? Which one do you think would be better to payoff first and what are your reasons? Please feel free to share.
Photo credits: Microsoft Clip Art