What to pay first?

[natron]

Hello, perhaps you can offer advice or point me to some past posts regarding this topic.  My wife and I have some extra money coming in lately and we're not sure what to do with it, but we're considering these 3 options:

Pay down mortgage - We owe 64k on a house (just purchased 3 months ago) at 4% interest
Pay down student loan - Wife has a student loan for 40k at 7% interest
Invest in index funds
Build up savings (we currently have only 9k)

We were originally thinking to pay down the student loan, but I read somewhere on this site that it might be good to pay mortgage first, because then we can get a line of credit on that money in case we need access to it.

What are your thoughts?

[clarkm04]

Not enough info.

Do you have a PMI on your mortgage?

Do you have any credit card debt that is earning interest? If so, what is/are the APR(s)?

How stable are your jobs?  This can alter whether your emergency fund is adequate.

Do either of you have a 401K through work that has a matching program?  If so, hit that match ASAP since that's free money.

From what little you posted, I'd pay off the student loans first at 7%.  If you have credit cards you didn't write about with higher APR than 7, I'd pay those off.  If you have a PMI, I'd pay down your mortgage to eliminate that first before tackling the student loans.

[natron]

Thanks for your reply clarkm04.

Yes, we have PMI on mortgage, credit cards are all paid off, and I have a stable job that I don't enjoy and we each own a business - mine growing, my wife's stagnant. We have one 11 month old child.

We also would like to eliminate one of the monthly payments as soon as possible, because when our monthly cash outflow drops, I will feel able to quit my job and invest fully in the business (will be easy to double sales 1 year) and sell off a vehicle

We live very frugally.

[clarkm04]

You and I are in similar situations then.

My wife and I wanted to buy a house close to my work so I could walk to work and one opened that fit all our needs before we had 20% down.  Thus, we have PMI.  Since there's no prepayment penalty on our loan, I'm treating that has a hair on fire emergency since it's additional interest with no value for us.  We are aggressively making payments to get the PMI gone.  Once the loan gets to 80% LTV (either through prepayment or housing price inflation), a letter is submitted to the lender to eliminate PMI.  Once the loan gets to 78% LTV, the PMI is automatically removed if the borrower doesn't submit a letter.

The only other consideration is the SL at 7%.  Since ours SL are locked at 3.25%, it was an easy decision to attack the PMI.  If you can't consolidate and lower the SL APR, that might be slightly better than wiping out your PMI but you'd have to run the numbers.

There was a previous posting on the forum with a formula to calculate effective interest rate on PMI.  The effective interest rate changes as you get closer to 80% since the PMI is covering less principle.

Good luck!

An additional advantage of wiping out the PMI, is that you also cut the mortgage loan timeline.

[nyxst]

Watch the PMI rules.. It has been many years since I had PMI insurance on my house, but I remember getting down to 80% LTV and then they told me that I had to be at 80% AND have had the loan for 5 years before they could remove it.... Just look into it.  I think I had to do a full refi with closing costs and everything to get out of the PMI, which still worked out to be more cost effective.

[Cheddar Stacker]

Your $9K savings is 14% of your home loan (9/64=14%). If you already put 5% down on the house you could likely eliminate PMI very, very soon by dumping the emergency fund at it. If you put it towards the mortgage you can likely get it right back with a home equity credit line in an emergency. I'd run the numbers like Clarkm04 said to calculate effective interest rate on PMI.

The student loan interest rate is a real problem as well. If you can't consolidate to get a better rate, you should pay that first unless the mortgage interest plus PMI effective interest exceeds it.

In your analysis, don't forget to consider tax deductions. Your net interest rate for the SL would be 7% * (1 - tax rate). Mortgage would be (4%+PMI%) * (1 - tax rate). Also, pay attention to whether or not you are actually getting a deduction for these things. With the low mortgage principal your total interest for the year is not very high, so you might be taking the standard deduction which means you're not even really using the mortgage interest deduction. Student loan interest can be deducted in addition to the standard deduction so you can double dip, but if your combined wages are north of $125K you might not be able to deduct much student loan interest at all. If either of these deductions are eliminated, the gross rate is your true rate. If they are reduced, reduce the tax rate accordingly.

If I were you I wouldn't start investing (other than 401K up to employer match) until you get rid of all loans with an after tax interest rate > 4-5%. Even after that, it's a personal choice, but the math favors investing around that point.