32

I have $11,000 to put toward one of my three loans. I think I should pay off the 0% car loan and then in two months it will be zero and I can apply that $635 to the 2.5 % car loan and pay it down faster. Does that make the best money sense?

Balance 4/25/2016

+-----------+------------+-------------+-------------+-------------+
| Type      |   Rate     | Tenor End   | EMI         | Balance     | 
+-----------+------------+-------------+-------------+-------------+
| Mortgage  | 3.625%     | 01-May-2045 | 2811.00     |431,431.23   |
| Car Loan  | 0.000%     | 28-Feb-2018 |  635.23     | 14,609.95   |
| Car Loan  | 2.540%     | 07-Oct-2020 |  419.61     | 19,397.58   |
+-----------+------------+-------------+-------------+-------------+
  • 23
    Isn't it obvious that you ALWAYS have to pay the highest interest loan first? That is, unless you have a delinquent loan/default, which could affect pretty badly your credit score. But even in this case, the interest rate would probably be higher, and the rule applies in the same way. – Quora Feans Apr 26 '16 at 20:55
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    Never pay off a 0% loan. (Because "0%" means that you had paid all the interest upfront so by paying it off you're dumping a service that had been already paid) – Agent_L Apr 27 '16 at 10:42
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    If you paid $2811 per month on the 3.625% mortgage you would end up paying it off by about September 2033 not May 2045. – Victor Apr 27 '16 at 11:43
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    @QuoraFeans "always" is a bit strong... There is a middle road: Pay off the lower interest, larger car loan... Less interest paid, $420 more flexibility a month sooner. Hell... paying off both car loans ASAP would net ~1050 a month in more flexibility. – WernerCD Apr 27 '16 at 14:20
  • 3
    Does the 0% rate have any form of compliance stipulation? For instance, if you miss a payment, does the rate change? Or are the terms static? – K. Alan Bates Apr 27 '16 at 20:00

13 Answers 13

55

By paying the $11,000 into the 2.54% loan you will save $23.30 in interest every month. By paying the $11,000 into the 3.625% loan you will save $33.20 in interest every month.

If your objective is to get rid of one loan quicker so repayments can go to the other loan to pay off sooner, I would put the $11,000 into the 2.54% loan and pay that off as quick as possible, then put any extra payments into the mortgage at 3.625%. Pay only the minimum amounts into the 0% car loan as this is not costing you anything.

  • 34
    Or more accurately, that 0% loan had all their interest costs baked into the principle and price of the car... those sneaky bastages. – corsiKa Apr 26 '16 at 15:05
  • 8
    It is important to note that this will spend money to achieve a feeling of doing something good. Objectively, this strategy wastes money for no non-emotional benefit. – boot4life Apr 26 '16 at 19:58
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    @boot4life It lowers your minimum monthly payment faster, which offers more financial flexibility. In 1.8 years your min monthly payment on your loans drops by 420$, or ~5000$ per year. If you choose to put this towards the mortgage, the cost for this is ~330$ total (as opposed to paying off the mortgage) over the next 5 years or so. So you pay 330$ in exchange for having the option not to put 15000$ towards your loans if you have the need, or 2.2% of the semi-freed up money (naturally the cost increases if you choose not to put it towards the mortgage after the car loan goes away). – Yakk Apr 27 '16 at 1:40
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    Shouldn't paying to the highest interest loan always save the most amount of interest? In your first paragraph you call that out as well. – boot4life Apr 27 '16 at 10:59
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    @boot Because predicting if you will need the cash or not is hard. Suppose you followed your strategy, and kept some cash in a bank account for 5 years. 3.625%*5 years is 18.1%, 330/18.1% is about 1500$. To be explicit: pay off 2.5% car loan with 11k, finish loan in 1.8 years, put payment towards paying off mortgage costs you 330$. Putting 9500$ toward mortgage, keep 1500$ in savings, after 5 years put 1500$ into mortgage also costs you 330$. (Compared to putting everything in morgtage). Thr car loan payoff gives more financial flexibility than the savings account solution. – Yakk Apr 27 '16 at 11:34
32

See many past answers: you will usually save the most money by paying off the highest-intetest-rate loan first. (Remember to allow for tax effects, if any, when comparing real interest rates.)

Some folks are more motivated to simplify their finances than to save money; in that case you might pay off the smallest loan first.

  • 8
    And in this case, there is the "middle" road: Pay off the middle interest loan to "Simplify AND save"... You get a mix of both. Lower interest paid AND lower monthly requirements. – WernerCD Apr 27 '16 at 14:15
20

This is more of an interesting question then it looks on first sight.

In the USA there are some tax reliefs for mortgage payments, which we don’t have in the UK unless you are renting out the property with the mortgage. So firstly work out the interest rate on each loan taking into account any tax reliefs, etc.

Then you need to consider the charges for paying off a loan, for example often there is a charge if you pay off a mortgage. These days in the UK, most mortgagees allow you to pay off at least 10% a year without hitting such a charge – but check your mortgage offer document.

How interest is calculated when you make an early payment may be different between your loans – so check.

Then you need to consider what will happen if you need another loan. Some mortgages allow you to take back any overpayments, most don’t. Re-mortgaging to increase the size of your mortgage often has high charges.

Then there is the effect on your credit rating: paying more of a loan each month then you need to, often improves your credit rating.

You also need to consider how interest rates may change, for example if you mortgage is a fixed rate but your car loan is not and you expect interest rates to rise, do the calculations based on what you expect interest rates to be over the length of the loans.

However, normally it is best to pay off the loan with the highest interest rate first.


Reasons for penalties for paying of some loans in the UK.

In the UK some short term loans (normally under 3 years) add on all the interest at the start of the loan, so you don’t save any interest if you pay of the loan quicker. This is due to the banks having to cover their admin costs, and there being no admin charge to take out the loan.

Fixed rate loans/mortgagees have penalties for overpayment, as otherwise when interest rates go down, people will change to other lenders, so making it a “one way bet” that the banks will always loose. (I believe in the USA, the central bank will under right such loans, so the banks don’t take the risk.)

  • 4
    +1 for including the need to account for tax advantages ('deductions' in US parlance) to figure the effective rate. – jamesqf Apr 26 '16 at 17:49
  • Penalties for overpaying loans still exist in the UK? I haven't seen that in the US in my lifetime – warren Apr 28 '16 at 18:14
  • 1
    @warren, see edit – Ian Apr 29 '16 at 17:02
6

This is a very complicated thing to try to do. There are many variables, and some will come down to personal taste and buying habits.

First you need to look at each of the loans and find out two very important things.

  1. Is there a penalty for paying early.
  2. Can you apply early payments to the principal.

Some times you pay a huge penalty for paying off a loan early. Usually this is on larger loans (like your mortgage) but it's not on heard of in car loans. If there is a penalty for early re-payment, then just pay off on the schedule, or at least take that penalty into consideration.

Another dirty trick that some banks do is force you to pay "the interest first" when making a early payment. Essentially this is a penalty that ensures you pay the "full price" of the loan and not a lessor amount because you borrowed for less time. The way it really works is complicated, but it's not usually to your benefit to pay these off early either. These usually show up on smaller loans, but better look for it anyway.

Next up on the list you need to look at your long term goals and buying habits. When are you going to re-model your kitchen. You can get another loan on the equity of the house, it's much harder to get a loan on the equity of a car (even once the car is paid off). So, depending on your goals you may do better to pay extra into your mortgage, then paying off your other loans early.

Also consider your credit score. A big part of it is amount of money remaining on credit lines/total credit lines. Paying of a loan will reduce your credit score (short term). It will also give you the ability to take out another loan (long term).

Finally, consider simplification of debtors. If something goes wrong it's much easier to work with a single debtor, then three separate debtors. This could mean moving your car loans into your mortgage, even if it's at a higher interest rate, should the need arise. Should you need to do that you will need the equity in your home.

Bonus Points: As others have stated, there are tax breaks for people with mortgages in some circumstances. You should consider those as well. Car loans usually require a different level of insurance. Make sure to count that as well.

Taking these points into consideration, I would suggest, paying off the 2.54% car loan first, then putting the extra $419.61 into your mortgage to build up more equity, and leaving the 0% loan to run it's full course. You all ready "paid for" that loan, so might as well use it.

Side note: If you can find a savings account or other investment platform with a decent enough interest rate, you would be better served putting the $419.61 there. A decent rate ROTH-IRA would work very nicely for this, as you would get tax deferment on that as well. Sadly it may be hard to find an account with a high enough interest rate to make it a more attractive option the paying off the mortgage early.

  • I don't get the "interest first" thing. Does that mean that they require interest payments for the time after you payed off the loan? – CodesInChaos Apr 27 '16 at 16:05
  • @CodesInChaos, yep. It's a dirty trick for sure, but basically they say your paying "next month" so they apply the "extra" money to next month's interest, then if there is any left over to the principal. Usually this happens when loan interest accrument exceeds loan payments. Student loans do this A LOT. Mortgages and car loans may do this of they offer a "special" or locked in payment type "deal". Sorry comments are too short for lots of details. See huffingtonpost.com/steve-rhode/… as example. – coteyr Apr 27 '16 at 17:01
  • I call it a dirty trick because they never should have written a loan with a repayment schedule like that. There's nothing illegal about it. Usually they hide this fact deep in the math where it's not obvious. – coteyr Apr 27 '16 at 17:06
  • That's only partly true. Even if the overage is applied to future payments instead of to principal you will shorten the term of the loan. Yes you pay more in interest today but you still reduce the future interest and get an earlier payoff with the added protection that if you miss a payment with a hardship in the future, the payment will come out of the overage instead of getting hit with a penalty. – Matthew Whited Apr 27 '16 at 19:13
  • Paying off a loan doesn't hurt your credit score – warren Apr 28 '16 at 18:16
6

Wow, you guys get really cheap finance. here a mortage is 5.5 - 9% and car loans about 15 - 20%.

Anyway back to the question. The rule is reduce the largest interest rate first ("the most expensive money"). For 0% loans, you should try to never pay it off, it's literally "free money" so just pay only the absolute minimum on 0% loans. Pass it to your estate, and try to get your kids to do the same. In fact if you have 11,000 and a $20,000 @ 0% loan and you have the option, you're better to put the 11,000 into a safe investment system that returns > 0% and just use the interest to pay off the $20k.

The method of paying off the numerically smallest debt first, called "snowballing", is generally aimed at the general public, and for when you can't make much progress wekk to week. Thus it is best to get the lowest hanging fruit that shows progress, than to try and have years worth of hard discipline just to make a tiny progress. It's called snowballing, because after paying off that first debt, you keep your lifestyle the same and put the freed up money on as extra payments to the next target. Generally this is only worth while if (1) you have poor discipline, (2) the interest gap isn't too disparate (eg 5% and 25%, it is far better to pay off the 25%, (3) you don't go out and immediately renew the lower debt. Also as mentioned, snowballing is aimed at small regular payments. You can do it with a lump sum, but honestly for a lump sum you can get better return taking it off the most expensive interest rate first (as the discipline issue doesn't apply).

Another consideration is put it off the most renewable finance. Paying off your car... so your car's paid off. If you have an emergency, redrawing on that asset means a new loan. But if you put it off the house (conditional on interest rates not being to dissimilar) it means you can often redraw some or all of the money if you have an emergency. This can often be better than paying down the car, and then having to pay application fees to get a new unsecured loan. Many modern banks actually use "mortgage offsetting" which allows them to do this - you can keep your lump sum in a standard (or even fixed term) and the value of it is deducted "as if" you'd paid it off your mortgage. So you get the benefit without the commitment. The bank is contracted for the length of the mortgage to a third party financier, so they really don't want you to change your end of the arrangement. And there is the hope you might spend it to ;) giving them a few more dollars. But this can be very helpful arragement, especially if you're financing stuff, because it keeps the mortgage costs down, but makes you look liquid for your investment borrowing.

5

Your goal of wanting to eliminate your debts early is great.

Generally, you can save more money by paying off loans with higher interest rates first.

However, it sounds like you are excited about the idea of eliminating one of your car loans in two months. There is nothing wrong with that; it is good to be excited about eliminating debt. I like your plan.

Pay off the $14.6k loan first, then apply the $635 monthly payment to the $19.4k loan. You'll have that loan paid off almost 3 years early. Perhaps you'll find some additional money to apply to it and get rid of it even earlier.

After you've eliminated both car loans, save up that $1000/month for your next car. That will allow you to pay cash for it, which will allow you to negotiate the best price and save interest. 0% loans are not free money.

Other answers will tell you to wait as long as possible to pay off your 0% loan, but I think there can be good reasons to eliminate smaller loans first, regardless of interest.

  • 2
    The problem with your answer is that the OP already has the 0% loan not looking to get one, so any penalty has already been paid. As long as the OP keeps making the minimum payments on time, as with the other loans, there would be no more penalty to pay on the 0% loan, however, the OP will still be paying interest on the other 2 loans in the mean time. – user9822 Apr 26 '16 at 22:19
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    @MarkDoony I have already noted that in both my second sentence here and in my other post about paying off a 0% loan. I stand by the notion that since 0% loans are a bad idea, it is in your best interest (no pun intended) to remove them from your life as quickly as possible and build up cash to pay for the next car, breaking the car loan cycle. Trying to optimize the math here is short-sighted: it's not about how many pennies of interest you will save on this loan, but how much you can save in the future by improving your behavior. – Ben Miller - Reinstate Monica Apr 27 '16 at 3:21
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    You're incorrect about 0% loans not being "free money". If you buy a new car at 0%, you're getting "free money". Whether or not a new car is of appropriate value to you is an entirely different question. I've done 0% on new cars twice - the new car was worth it both times to me, and I got the employee/partner price both times, so I got the lowest the dealer would go each time. – warren Apr 28 '16 at 18:18
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    Ben: I did the evaluation of used vs new, and the new was better both times for me. It may not be better for everyone. – warren Apr 29 '16 at 12:16
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    @BenMiller, your basing this on assuption, you don't know what kind of deal the OP got. Your whole answer is based on assuptions not fact. – user9822 Apr 29 '16 at 21:35
3

This is a case where human nature and arithmetic lead to different results.

Depending on the your income, the effective interest rate on the mortgage is probably right around 2.5%. So purely by arithmetic, the absolute cheapest way to go is to put the $11k to the bigger car loan, then pay off the mortgage, then the smaller car loan.

The Debt Snowball is more effective however, because it works better for people. Progress is demonstrated quickly, which maintains (and often enhances) motivation to continue. I can say as a case in point, having tried both methods, that if does indeed work.

So, I am with you ... pay off the car loan first, and roll that payment into the bigger car loan. If you add no extra dollars, you should get the small loan paid off in 6 to 8 months and the bigger car loan in another 16 to 18 months.

It sounds like from your message that you have another $1500 or so a month. If that is the case ... small loan paid off in two months, bigger loan paid off in another year.

If you stick with the Ramsay program, you then build an emergency fund and start investing.

Good luck!

  • 1
    "The Debt Snowball is more effective however, because it works better for people." - for some people. (I would never hurry to pay off a 0% interest loan, no matter how small, just so that I could say "I paid off a debt",) – Joe Strazzere Apr 27 '16 at 13:22
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    Joe, you missed the point. You don't pay it off early so you can say you paid it off. You pay it off early to help maintain motivation toward the goal of getting out of debt. When the smaller debt is paid off you feel as though you have accomplished something toward getting out of debt. If you pay off the smaller debt first you pay $50 more of interest payments, but if you lose motivation toward getting out of debt, you might slow down the process and end up paying much more than $50 in interest because you didn't remain motivated. Everyone knows the math. Few understand the psychology. – Itsme2003 Apr 27 '16 at 20:48
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    This is backed by research - kellogg.northwestern.edu/news_articles/2012/…. – Brad Werth Apr 28 '16 at 13:22
  • Brad - sorry, the linked article is useless. It begins with data from a debt settlement company. That's not a sample population. Unfortunately, the final full article is pay-walled and $20 for the single article. To be clear, I'd concede that "In their analysis, Gal and McShane found that consumers who pursued the 'small victories' strategy were more likely to eliminate their entire debt balance." I just find the article itself lacking in compelling information. – JTP - Apologise to Monica Apr 29 '16 at 10:57
3

Allen, welcome to Money.SE. You've stumbled into the issue of Debt Snowball, which is the "low balance" method of paying off debt. The other being "high interest." I absolutely agree that when one has a pile of cards, say a dozen, there is a psychological benefit to paying off the low balances and knocking off card after card. I am not dismissive of that motivation. Personal Finance has that first word, personal, and one size rarely fits all. For those who are numbers-oriented, it's worth doing the math, a simple spreadsheet showing the cost of the DS vs paying by rate.

If that cost is even a couple hundred dollars, I'll still concede that one less payment, envelope, stamp, etc, favors the DS method. On the other hand, there's the debt so large that the best payoff is 2 or 3 years away. During that time, $10000 paid toward the 24% card is saving you $2400/yr vs the $500 if paid toward 5% debt. Hard core DSers don't even want to discuss the numbers, strangely enough.

In your case, you don't have a pile of anything. The mortgage isn't even up for discussion. You have just 2 car loans. Send the $11,000 to the $19K loan carrying the 2.5%. This will save you $500 over the next 2 years vs paying the zero loan down. Once you've done that, the remaining $8000 will become your lowest balance, and you should flip to the Debt Snowball method, which will keep you paying that debt off.

DS is a tool that should be pulled out for the masses, the radio audience that The David (Dave Ramsey, radio show host) appeals to. They may comprise the majority of those with high credit card debt, and have greatest success using this method. But, you exhibit none of their symptoms, and are best served by the math. By bringing up the topic here, you've found yourself in the same situation as the guy who happens to order a white wine at a wedding, and finds his Mormon cousin offering to take him to an AA meeting the next day.

In past articles on this decision, I've referenced a spreadsheet one can download. It offers an easy way to see your choice without writing your own excel doc. For the situation described here, the low balance total interest is $546 vs $192 for the higher interest. Not quite the $500 difference I estimated. The $350 difference is low due to the small rate difference and relatively short payoffs. In my opinion, knowledge is power, and you can decide either way. What's important is that if you pay off the zero interest first, you can say "I knew it was a $350 difference, but I'd rather have just one outstanding loan for the remain time." My issue with DS is when it's preached like a religion, and followers are told to not even run the numbers. I wrote an article, Thinking about Dave Ramsey a number of years back, but the topic never gets old.

2
  1. Use the $11k to pay down either car loan (your choice). You should be able to clear one loan very quickly after that lump sum.

  2. After that, continue to aggressively pay down the other car loan until it is clear.

  3. Lastly, pay off the mortgage while making sure you are financially stable in other areas (cash-on-hand, retirement, etc)

Reasoning:

  1. The car loans are very close in value, making it a wash as far as payoff speed.

  2. The 2.54% interest is not a large factor here. As a percentage of all these numbers, the few bucks a month isn't going to change your financial situation. This is assuming you will pay off both loans well ahead of schedule, making the interest rate negligible in the answer.

  3. Paying off the mortgage last is due to the risk associated with the car loans. The cars are guaranteed to lose value at an alarming rate. While a house certainly may lose value, it is far from an expectation. It is likely that your house will maintain and/or increase in value, unless you have specific circumstances not disclosed here. This makes the mortgage a lower risk loan in your financial world. You can probably sell the house to clear the loan balance if necessary. The cars are far more likely to depreciate beyond the loan balance.

1

Aside from the calculations of "how much you save through reducing interest", you have two different types of loan here.

The house that is mortgaged is not a wasting asset. You can reasonably expect that in 2045 it will have retained its worth measured in "houses", against the other houses in the same neighbourhood. In money terms, it is likely to be worth more than its current value, if only because of inflation. To judge the real cost or benefit of the mortgage, you need to consider those factors. You didn't say whether the 3.625% is a fixed or variable rate, but you also need to consider how the rate might compare with inflation in the long term. If you have a fixed rate mortgage and inflation rises above 3.625% in future, you are making money from the loan in the long term, not losing what you pay in interest.

On the other hand, your car is a wasting asset, and your car loans are just a way of "paying by installments" over the life of the car. If there are no penalties for early repayment, the obvious choice there is to pay off the highest interest rates first.

You might also want to consider what happens if you need to "get the $11,000 back" to use for some other (unplanned, or emergency) purpose. If you pay it into your mortgage now, there is no easy way to get it back before 2045. On the other hand, if you pay down your car loans, most likely you now have a car that is worth more than the loans on it. In an emergency, you could sell the car and recover at least some of the $11,000. Of course you should keep enough cash available to cover "normal emergencies" without having to take this sort of action, but "abnormal emergencies" do sometimes happen!

1

While, from a money-saving standpoint, the obviously-right course of action is to make only the minimum payment on the 0% loan, there are potentially legal reasons to try to pay off a car loan early. With a mortgage, you are the legal owner of the property and any action by the lender beyond imposing fees (e.g. foreclosure) requires going through the proper legal channels. On the other hand, in most jurisdictions, you are not the legal owner of a car purchased on a loan, and a missed or even lost payment can result in repossession without the lender even having to go to court. So from a risk-aversion standpoint, there's something to be said for getting rid of car loans as soon as you can.

  • Downvoter care to comment? – R.. Apr 29 '16 at 4:13
  • 1
    The one thing about SE that can be irritating. Although I understand a forced reason for DV can just start an argument, these DVs are just irksome. Your answer makes a point that's valid and that others didn't mention. A +1 from me. – JTP - Apologise to Monica Apr 29 '16 at 15:10
0

At the moment, you are paying about $1,300 interest each month (£431k @ 3.625% / 12) on your mortgage and repaying capital at about $1,500 per month.

Paying $11,000 off your mortgage would save you about $9,000 as it is reduces your balance by about seven monthly capital repayments: but you will only see this benefit at the end of the mortgage because you will pay it off seven months earlier.

There is only about $1,000 interest remaining on your car loans. Paying the $11,000 off your interest free loan then paying extra agianst the interest bearing loan brings that down to $500 and paying it off your interest bearing loan brings it down to $200. Either way, both car loans would be finished by early 2018.

In summary, if you use the $11,000 against your car loans, you will save $8,500-$8,800 less than paying it off the mortage, but you will have no car loans in one year rather than three.

Google spreadsheet for calculations here.

-3

Keep in mind that by fully paying off one of your loans, you will reduce your minimum repayments.

This will make you feel richer than you actually are. This will make you buy stuff that it seems like you can afford, probably putting some of it on credit.

As you can't actually afford this, this will leave you, in a years time, with the same amount of debt you have now or more, but with a slightly bigger tv.

Assuming your home loan has no penalties for paying off extra, then put all 11k into there to keep your monthly repayments as high as possible.

  • This is always a danger when in the midst of a debt reduction ... the temptation to borrow again. – tomjedrz Apr 27 '16 at 3:20
  • Indeed, and easier to avoid that temptation if you have monthly repayments hanging over your shoulder. – Scott Apr 27 '16 at 5:13
  • 6
    Staying in debt to reduce one's inclination to get into debt seems like one odd tool to me. – Ghanima Apr 27 '16 at 9:32
  • OP is staying in debt, Ghanima, regardless of what he does with that $11,000. That you forgot this demonstrates my point. – Scott Apr 27 '16 at 23:52
  • I certainly did not forget. Maybe my comment is slightly exaggerated but only to make my point. I understand the notion or lets say the psychological effects intended I am just saying that I'd not consider it the best tool in the box to achieve a behavioural change. – Ghanima Apr 29 '16 at 9:26

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