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My situation is that I'm receiving a one time lump sum. I have two debts to pay off.

  • Debt A, interest rate 3.5%, smaller installments
  • Debt B, interest rate 4.5%, bigger installments

From this, the obvious choice would be to put the lump sum toward debt B. However, debt B's interest is fully deductible from my taxes, and I expect to pay taxes for the foreseeable future. I'm in Finland, but I'm looking for a more general answer.

So, do I take that into account? Should I consider debt B to have zero, or discounted interest?

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    All tax questions require disclosing the country otherwise you will get general answers.
    – mhoran_psprep
    Jun 19 at 11:05
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    @mhoran_psprep I'm not sure the details of tax laws matter all that much for what I'm asking.
    – HAEM
    Jun 19 at 21:19
  • You should pay off whichever loan has the smallest balance and roll the money into the other one. Think how nice it would be to kill it.
    – DeepDeadpool
    Jun 20 at 11:30
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    @computercarguy But it is enough to provide some guidance on how to make the decision.
    – glglgl
    Jun 21 at 6:37
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    @computercarguy If I did provide that amount of detail, it would invite answers that are only useful for me. I am not asking for the particular math, I am asking if and how to include this thing in the math.
    – HAEM
    Jun 21 at 19:52

2 Answers 2

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Why zero interest? You consider the interest rate of B multiplied by 100% minus your marginal tax rate, divided by 100%. (Provided the Finnish tax system works as others with a progressive tax and the interest is deductible as "usual" costs. If that isn't the case, adjust my assumptions accordingly.)

So let's assume your marginal tax rate is 30%. Then you can get 30% of the interest of debt B back from the taxes, leaving you with 70%, i. e. 3.15%.

So after taxes, debt B is cheaper than debt A and you should pay off debt A first.

With a marginal tax rate of 22.2%, both debts have the same cost. At a higher rate, B is cheaper (as above), at a lower rate, A is cheaper.

Disclaimer again: Take the answer with a grain of salt - if the Finnish tax system contains any traps or irregularities I am not aware of, the results might be different.

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    First make sure that you will actually be itemizing! Just because the debt is deductible doesn't mean you will actually be getting a deduction for it. Since 2017 (in the US) most people will be better off taking the standard deduction.
    – Nobody
    Jun 19 at 15:30
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    @Nobody These are details of the US tax system, which I don't know much about. Thus the disclaimer at the end.
    – glglgl
    Jun 19 at 18:18
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    The veil of secrecy has been lifted, they've updated the question to say Finland.
    – Barmar
    Jun 20 at 14:34
  • @Barmar Thanks, I updated my answer accordingly.
    – glglgl
    Jun 21 at 6:41
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There are two basic trains of thought on reducing debt. The first is the debt snowball. That is you pay off your debts smallest to largest and use the increased cash flow to pay off the larger debts sooner. This can work surprisingly well as opposed to the other method which seems superior on the surface. Cash flow, to a person passionately committed to paying off debt, is the key to success.

The second is the "debt avalanche" this is where you pay off the highest interest rate first.

Even without the tax deductibility I might put the lump sum towards Debt A. If that lump sum would pay off, or nearly pay off Debt A. Then without question I would use the lump sum towards A.

The debt avalanche method would agree with this depending on the effective interest rate of debt B. Once you factor in the tax deduction how much are you actually paying towards that loan. If its less than 3.5%, the the avalanche method would agree with putting the money towards A.

So a little math is necessary to figure out the effective interest rate of B.

To make a clear choice what are the balances of A and B? How much is the lump sum? Will the installments decrease if the loans are paid down, or is that fixed?

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    one thing that has to be considered is that in the United States, the tax savings only happens if you itemize your deductions. But that tax savings is only the percentage of the delta between itemizing and the standard deduction. Some people are surprised by this when they figure their taxes. They can pay thousands in interest for hundreds in tax savings.
    – mhoran_psprep
    Jun 19 at 15:22
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    @mhoran_psprep In the US, the only interest that's still deductible is mortgage debt. I think Trump's tax cuts did away with investment interest deduction.
    – Barmar
    Jun 20 at 14:37
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    @Barmar: no TCJA did not remove investment interest -- although as noted on the other answer it does make itemization nonbeneficial for many, and investment interest is itemized; see form 4952 and Schedule A. TCJA does remove (technically, suspend) all 2%-floor deductions, which includes non-interest investment expenses like account fee, or safe-deposit box if you still have bearer instruments(!)
    – dave_thompson_085
    Jun 21 at 1:56
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    @Barmar your comments are pretty much NA to the OP as they are in Finland. mhoran's comments are applicable as depending on the laws not the full amount may be deductible.
    – Pete B.
    Jun 21 at 15:30
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    When you say, "This can work surprisingly well" with regard to the 'snowball' method, you're referring to the psychological effect of seeing debts paid off, right? From a purely mathematical perspective (i.e. if you are going to pay the exact same total amount towards the loans each month,) it's always best to pay down the debt with the highest effective (i.e. after adjustments for tax considerations) interest rate first, no? (With obvious exceptions for cases where a loan's effective interest rate will increase if it isn't paid off early.)
    – reirab
    Jun 21 at 17:05

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