9

I received a good bonus this year and am trying to figure out the best way to use it. I have no credit card or student debt, maintain an emergency fund, and am maxing out tax advantaged retirement savings; I'm also paying off two loans - a car loan and a mortgage.

Reading personal finance advice, it seems they generally say first pay off all debt except a mortgage and then either save more for retirement or pay off the mortgage. But my mortgage has a higher interest rate than my car loan (3.1% apy vs 1.9% apy) and I'd generally think I should pay off the highest interest debt first. I know the mortgage interest tax deduction should be factored in, but does that outweigh the difference in interest rates?

Also I question whether I should prepay either of these loans vs investing in an index fund? I know some people like the security of owning their home outright, but honestly I can't see my parents (the mortgage holders) evicting me if a life catastrophe resulted in a missed payment.

9

Pay off your car loan. Here is why:

  1. As you mentioned, the interest on your home mortgage is tax deductible. This may not completely offset the difference in interest between your two loans, but it makes them much closer.

  2. Once your car debt is gone, you have eliminated a payment from your life. Now, here's the trick: take the money that you had been paying on your car debt, and set it aside for your next car. When the time comes to replace your car, you'll be able to pay cash for your car, which has several advantages.

  • 3
    Agree. The car is also a depreciating asset, so be sure to never be upside-down on the loan and pay it off then drive it for as long as you can. – Rocky Jan 1 '15 at 17:57
  • 1
    +1 - The rates are close enough, maybe 2.3% mort after tax, versus 1.9% car loan, that the length of the loans comes into play. Paying this off frees up that cash flow. – JoeTaxpayer Jan 1 '15 at 18:58
  • Isn't the interest from a car loan also tax deductible? – Sun Jan 5 '15 at 20:14
  • The mortgage is not in your name anyway, so this makes even more sense to pay off the car loan first (assuming the car the is in your name). – Sun Jan 5 '15 at 20:17
  • @sunk818 Car loan interest in not generally tax deductible in the US. – Ben Miller Jan 5 '15 at 20:53
3

First off, the "mortgage interest is tax deductible" argument is a red herring. What "tax deductible" sounds like it means is "if I pay $100 on X, I can pay $100 less on my taxes". If that were true, you're still not saving any money overall, so it doesn't help you any in the immediate term, and it's actually a bad idea long-term because that mortgage interest compounds, but you don't pay compound interest on taxes.

But that's not what it actually means. What it actually means is that you can deduct some percentage of that $100, (usually not all of it,) from your gross income, (not from the final amount of tax you pay,) which reduces your top-line "income subject to taxation." Unless you're just barely over the line of a tax bracket, spending money on something "tax deductible" is rarely a net gain.

Having gotten that out of the way, pay down the mortgage first. It's a very simple matter of numbers:

Anything you pay on a long-term debt is money you would have paid anyway, but it eliminates interest on that payment (and all compoundings thereof) from the equation for the entire duration of the loan. So--ignoring for the moment the possibility of extreme situations like default and bank failure--you can consider it to be essentially a guaranteed, risk-free investment that will pay you dividends equal to the rate of interest on the loan, for the entire duration of the loan.

The mortgage is 3.9%, presumably for 30 years. The car loan is 1.9% for a lot less than that. Not sure how long; let's just pull a number out of a hat and say "5 years."

If you were given the option to invest at a guaranteed 3.9% for 30 years, or a guaranteed 1.9% for 5 years, which would you choose? It's a no-brainer when you look at it that way.

2

A point that hasn't been mentioned is whether paying down the mortgage sooner will get you out of unnecessary additional costs, such as PMI or a lender's requirement that you carry flood insurance on the outstanding mortgage balance, rather than the actual value/replacement cost of the structures. (My personal bugbear: house worth about $100K, while the bare land could be sold for about twice that, so I'm paying about 50% extra for flood insurance.) May not apply to your loan-from-parents situation, but in the general case it should be considered.

FWIW, in your situation I'd probably invest the money.

0

Without knowing actual numbers it's tough to say. Personally, I would pay off the car then, going forward, use the money that would have been paid on your car note toward your mortgage. I always think of things in the worst possible scenario. It's easier, and faster, to repossess a car than to foreclose on real estate. Also, in an emergency situation, depleting your fund for your car loan and your mortgage would be significantly more detrimental than only paying a mortgage with a car owned outright. Fewer obligations means fewer things to draw down your funds in an emergency.

Whether the tax deductability of the mortgage interest outweighs the lower rate on your car loan will depend on a lot of factors that haven't been shared. I think it's safe to assume with only 1% of separation the real difference isn't significant.

I think when determining which credit cards to pay off, choosing the one with the highest rate is smart. But that's not the situation you're in.

If you don't have foreclosure concerns I'd still pay off the car then start investing.

0

Since you've already maxed out your 401k and your IRA, if you wanted to invest more-- then it would either be in a brokerage account or a 529 (if you have kids/ intend on going back to school).

As to investing versus paying off your loans -- the interest on them are small enough that it will depend on your preference. If you need the cash flow for investment purposes (ie if you are going to buy an investment property) then I would pay off the car loan first -- otherwise I would invest the money.

Since you've already expressed that you wouldn't be too interested in paying the mortgage off early, I've left that off the table (I would prioritize car loan over mortgage for the cash flow reason)

If you do open a brokerage account -- make sure you are minimizing your taxes by putting the 'right' type of assets in a tax advantaged account.

0

It depends on your tax rate. Multiply your marginal rate (including state, if applicable) by your 3.1% to figure out how much you are saving through the deduction, then subtract that from the 3.1% to get the effective rate on the mortgage. For example, if you are in the 28% bracket with no state tax impact from the mortgage, your effective rate on the mortgage is 2.232%. This also assumes you'd still itemize deductions without the mortgage, otherwise, the effective deduction is less.

Others have pointed out more behavioral reasons for wanting to pay off the car first, but from a purely financial impact, this is the way to analyze it. This is also your risk-free rate to compare additional investing to (after taking into account taxes on investments).

protected by Community Aug 21 '15 at 15:28

Thank you for your interest in this question. Because it has attracted low-quality or spam answers that had to be removed, posting an answer now requires 10 reputation on this site (the association bonus does not count).

Would you like to answer one of these unanswered questions instead?

Not the answer you're looking for? Browse other questions tagged or ask your own question.