Which debt to reduce first?
April 2nd, 2006 | by mbhunter |I saw a heartening post over in the SavingAdvice.com forums this week.
A couple has extra money that they want either to put toward debt (nearly $4000/month in two mortgages for their Los Angeles home) or put in savings. This kind of thinking seems very uncommon.
The skinny on their loans:
Mortgage one – 30 yr fixed
Monthly minimum payment – $3,054.70
Principal Balance on 3/14/06 – $511,567.71
Interest rate – 5.875%
Mortgage two - 15 yr fixed
Monthly minimum payment – $850.12
Principal Balance on 2/1/06 – $93,772.42
Interest rate – 6.625%
They do have a bit of a savings cushion, so the need to build up an emergency fund isn’t especially urgent.
So, then the question is: Where do they put extra money?
Both of the other debts are against non-income-producing assets, so it makes good sense to pay them off faster than the amortized payment.
If it were I, I’d try to knock off Mortgage 2 before tackling Mortgage 1, for a few reasons:
- The interest rate is higher on Mortgage 2. The effective “return” on extra principal is 6 5/8% (minus any lost tax deductions) as opposed to 5 7/8%. The extra paid principal works harder at saving you interest.
- The amount owed is lower. Once Mortgage 2 is paid off, that entire payment is freed for other purposes — like paying off Mortgage 1! There would be two loans carried for longer if the money were thrown at Mortgage 1.
- Mortgage 2 has a shorter term. Who thinks that there is going to be deflation? I don’t. (But, pigs could indeed fly tomorrow.) My point is that Mortgage 2, with its shorter term, won’t benefit from dollar depreciation nearly as long as Mortgage 1. Twenty years into the loan, their $3k mortgage payment will be due, and they’ll look in their wallet, because that will be pocket change in 2026. Maybe not quite, but it will almost certainly be a lot less of a pain to shell out $3k than it is now.
Even if they decide to do something else (it looks like they’ll be throwing the extra payments toward Mortgage 2, though!) there are many, many, MANY worse things to do with $500/month than reduce your debt.
Any other reasons for or against what I’ve said?
One Response to “Which debt to reduce first?”
By fivecentnickel.com on Apr 2, 2006 | Reply
This seems like a no-brainer to me… Kill mortgage #2. It has a higher rate, so it makes sense to pay it down first. I’m not sure why anyone would ever pay of the cheaper money faster. There might be circumstances in which it’s warranted — like if you’re using the debt snowball and the debt with the lowest balance also happens to have the lowest interest rate (Ramsey says pay of lowest balance first regardless of interest rates).