0

I have $15,000 that I am trying to put towards one of my loans. Right now I have two loans

  • $14,000 3.7% variable interest, 10 years, $140 monthly payment
  • $30,000 7% fixed interest, 15 years, $260 monthly payment

Normally you are supposed to pay off the one with the higher interest rate first. But I am not sure the correct choice in this situation. I can put the 15k towards the $14,000 loan and use the monthly payments to pay off more of the $30,000 loan. Or I can put the 15k towards the $30,000 loan and then just continue making my typical monthly payments.

What is the correct choice here to save the most money?

  • 3
    Pay the higher interest loan first since it's costing you more. Try to put together a simple spreadsheet to model various payment schemes and see this in action. – user2023861 Jul 18 '16 at 21:01
4

An extra payment on a loan is, broadly speaking, a known-return, risk-free investment. (That the return on the investment is in reduced costs going forward instead of increased revenue is basically immaterial, assuming you have sufficient cash flow to handle either situation.)

We can't know what the interest rates will be like going forward, but we can know what they are today, because you gave us those numbers in your question.

Quick now: Given the choice between a known return of 3.7% annually and a known return of 7% annually, with identical (and extremely low) risk, where would you invest your money?

By putting the $15k toward the $14k loan, you free up $140 per month and have $1k left that you can put toward the $30k loan, which will reduce your payment term by $1k / $260/month or about 4 months. You will be debt free in 14 years 8 months. You pay $14,000 instead of $16,800 on the $14,000 loan, reducing the total cost of the loan by $2,800, and reduce the cost of the $30,000 loan by four months' worth of interest which is about $175 (so the $30,000 loan ends up costing you something like $46,600 instead of $46,800).

By putting the $15k toward the $30k loan, you cut the principal of that one in half. Assuming that you keep paying the same amount each month, you will reduce the payment term by 7 ½ years, and will be debt free in 10 years (because the $14,000 10-year loan now has the longer term). Instead of paying $46,800 for the $30k loan, you end up paying $23,400 plus the $15,000 = $38,400, reducing the total cost of the $30,000 loan by $8,400 while doing nothing to reduce the cost of the $14,000 loan.

To a first order estimate, using the $15,000 to pay off the $14,000 loan in full will improve your cash flow in the short term, but putting the money toward the $30,000 loan will give you a three-fold better return on investment over the term of both loans and nearly halve the total loan term, assuming unchanged monthly payments and unchanged interest rates. That's how powerful compounding interest is.

  • The main confusion I was having if I paid off the $14,000 loan. Put the remaining $1000 into the $30k loan. And increased my monthly payments of the $30k loan by the money I was putting towards the $14,000 loan. So increase it by $140 per month. But I believe that is still less money saved than just putting $15k into the $30k loan – Johsh Hanks Jul 18 '16 at 23:05
  • Although correct that you want to prioritize paying off the higher interest, higher principal loan; halving the principal more than halves the payment term. The payment term is now 5 years and 8 months for the 15-year loan. After the 15-year loan is paid off, applying those payments to the 10-year loan will reduce its payment term by 3 years. So you should be debt-free in a little over 7 years. – TNgo Dec 8 '18 at 9:01

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

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