Author Topic: Question about paying off debt - 1st ver 2nd  (Read 6324 times)

zachd

  • Stubble
  • **
  • Posts: 102
Question about paying off debt - 1st ver 2nd
« on: April 15, 2014, 07:01:41 PM »

Originally I was going to post this as a math question as I can't quite do the math on it to see the numbers myself.  I might still do that if someone could help.

But instead I'll first just ask.. I see people usually say pay off your highest debt first. But, I don't think I've seen anyone recommend paying off their home mortgage before paying off their home equity loan.  Why is that?  I am aware there is some risk involved, but let's say there wasn't or you didn't care - why not?

If having numbers would help I can share but maybe there is something I don't know that makes this a bad idea and that's why everyone isn't doing it :)




            

AccidentalMiser

  • Pencil Stache
  • ****
  • Posts: 659
  • Age: 51
  • Location: SE Tenn
Re: Question about paying off debt - 1st ver 2nd
« Reply #1 on: April 15, 2014, 07:35:10 PM »
Are the tax consequences of each the same?  Is the first at a lower rate than the second?  Fixed or variable?  Are the loan lengths similar?

Hard to evaluate without numbers...

In my view, a loan is, in most cases, a loan.  I paid them off from high rate to low.  Mortgages have tax implications which have to be factored in to reach an effective rate.

zurich78

  • Stubble
  • **
  • Posts: 180
Re: Question about paying off debt - 1st ver 2nd
« Reply #2 on: April 15, 2014, 08:05:42 PM »
Yeah there are a lot of factors including loan types and interest rates to factor in as the poster above mentioned.

Frankly, I haven't heard that one should tackle their largest loan first.  The strategy many people employ, is paying off the debts that have the highest interest rates first, and then moving on to the smaller ones from there.  In most cases, the mortgage loan is among the lowest in interest rates.

I can tell you that from my personal experience, and what worked for me, is the debt snowball method.  I know that purely from a financial perspective, this wouldn't be the most advantageous, but I do believe in the psychological benefits associated with the debt snowball because it helped me stay on track.

Basically, the way that works is you pay the minimums on everything except the smallest of your debts and you put as much money toward paying the smallest debt first.  You will be able to pay off that debt faster than any other debt.  Once you have paid off the smallest debt, you take the payments you were making toward that smallest debt, add the minimum you were paying on the next highest debt and pay that.  Once that is paid off, you "snowball" the payments toward the next debt and so on.

The idea is that by doing it this way, each debt you pay off is a psychological win that will keep you motivated to continue paying down your other debts.  Sometimes, for some people, trying to pay down a larger debt first can feel like trying to chop down a tree with a Swiss Army knife.

zachd

  • Stubble
  • **
  • Posts: 102
Re: Question about paying off debt - 1st ver 2nd
« Reply #3 on: April 15, 2014, 08:18:12 PM »
I meant to say most people recommend paying of their highest interest rate loan first, not highest in the amount of debt. Yet I don't think I've come across anyone saying to pay off your mortgage first.  I'm not concerned with snowball effect or psychological wins, I'm more interested in which option would save the most money.

I have 3000 a month to pay towards either debt.

1st mortgage:
Rate   3.99%   20 Year   Balance   $130,500.00
            
Date            Payment   Principal   Interest   Tax & Insurance
January   1402.18   414.02   439.67   548.49

2nd / home equity loan
Rate   2.99%   Balance   $27,000.00

 Date   Description   Amount   Principal   Interest      Fees   Principal Balance   
March   REGULAR     287.14   208.72   78.42       0            28380.77   

zurich78

  • Stubble
  • **
  • Posts: 180
Re: Question about paying off debt - 1st ver 2nd
« Reply #4 on: April 15, 2014, 08:25:47 PM »
I have to say, I don't know how to calculate which one would save you the most money ... however, give the amount of time it would take to pay off the first mortgage, I'd have to imagine it would be most advantageous to attack the second one (the $27K one) first.  There has to be some factor where the amount of the debts impacts which one makes the most sense to play.

Without doing the math, my thinking is that you could pay that one off fairly quickly, and then make larger payments toward the first one.  So you'd paying down the big one slower at first, but then at some point you'd be making larger payments earlier against the large one because you'd no longer have the second one, if that makes sense.

Sorry, I'm just trying to get involved and help, I'm really no expert =)  But I'd love to hear from one!
« Last Edit: April 15, 2014, 08:27:21 PM by zurich78 »

zachd

  • Stubble
  • **
  • Posts: 102
Re: Question about paying off debt - 1st ver 2nd
« Reply #5 on: April 15, 2014, 08:31:23 PM »

Yeah, I am hoping someone can treat it as a math problem and show me the $ amount of one versus the other.

Applying $3k to the home loan it would be paid in about 3 years and I would save $50k in interest.
Applying it to the HELOC, it would be paid in 9 months - I'm not sure how much it would save there - the payments are 1% of the balance and I don't know how to do the math. It would be about $600-$700 though saved I believe.

EngineerMum

  • Stubble
  • **
  • Posts: 130
  • Location: Perth, Western Australia
  • Working towards moderate badassity
Re: Question about paying off debt - 1st ver 2nd
« Reply #6 on: April 16, 2014, 12:14:09 AM »
Pay highest interest first, all things being equal. We don't have HELOCs here (Aus) so I don't know if there are technical differences in the loan that offset the pure maths of the thing, but from a purely mathematical perspective, always pay the highest interest first. The number of loans you have makes absolutely no difference as far as interest goes, it's only relevant when there are fees on the loans.
The difference in benefit is the difference in interest charged on the amount extra you are paying. If there are fees applied to the cheaper loan then it sometimes makes sense to pay off low interest smaller loans first, (eg I pay the same fees on my mortgage whether I have $1 owing or $1M, so when I get to a point where the difference in interest charged is less than the annual fee, then I should just pay off the morty) however I think you said your heloc has no annual fee.
Effectively, if you have two loans (A and B) at interest rates x and y, then each period you are charged Ay + Bx. If y is bigger than x, you are better off reducing A faster than B - how much better? Simple - if your extra payment is C, then you are better off by C(y-x). In your case, that's $3000 x(1%/12) which is about $2.50 per month. Which of course compounds with each extra payment.

zachd

  • Stubble
  • **
  • Posts: 102
Re: Question about paying off debt - 1st ver 2nd
« Reply #7 on: April 16, 2014, 07:59:42 AM »

Thanks..  in my situation it is notable the payment on the HELOC is 1% of the balance each month.  Because of that I don't think you could compare them just by subtracting the interest rates to see the difference.  Maybe you still can, not sure, but the way the compute the interest on the HELOC is different (I think)

Cpa Cat

  • Handlebar Stache
  • *****
  • Posts: 1576
Re: Question about paying off debt - 1st ver 2nd
« Reply #8 on: April 16, 2014, 01:44:08 PM »
Well.. a home mortgage is only tax deductible if it's home acquisition debt. A home equity line of credit is deductible regardless of its purpose. A HELOC is usually a revolving line of credit too, so you could, in theory, be aggressive about paying it with your savings without having any serious worries about losing the "emergency fund."

So I suppose if I was going to carry debt, I'd rather it be a HELOC, because it creates deductible personal interest on a revolving line of credit. I could see the advantage of paying it down so that I could free it up for purchasing a car or something.

BUT - if you intended to pay off both regardless and not increase your debt at all, then I don't see the advantage of not simply paying off whichever had the higher interest rate - other than maybe keeping the safety net of an open HELOC to borrow against.

MDM

  • Walrus Stache
  • *******
  • Posts: 9495
Re: Question about paying off debt - 1st ver 2nd
« Reply #9 on: April 16, 2014, 02:38:54 PM »
zachd, do you have access to Excel?  If so, see http://office.microsoft.com/en-us/excel-help/using-the-loan-amortization-and-loan-analysis-templates-HA001034640.aspx?CTT=1&origin=EC001022983.

If that (in particular, the template(s) you can download from that link) doesn't answer your question, let us know.

Mister Fancypants

  • Bristles
  • ***
  • Posts: 296
  • Age: 42
  • Location: New York
Re: Question about paying off debt - 1st ver 2nd
« Reply #10 on: April 16, 2014, 03:47:23 PM »
I meant to say most people recommend paying of their highest interest rate loan first, not highest in the amount of debt. Yet I don't think I've come across anyone saying to pay off your mortgage first.  I'm not concerned with snowball effect or psychological wins, I'm more interested in which option would save the most money.

I have 3000 a month to pay towards either debt.

1st mortgage:
Rate   3.99%   20 Year   Balance   $130,500.00
            
Date            Payment   Principal   Interest   Tax & Insurance
January   1402.18   414.02   439.67   548.49

2nd / home equity loan
Rate   2.99%   Balance   $27,000.00

 Date   Description   Amount   Principal   Interest      Fees   Principal Balance   
March   REGULAR     287.14   208.72   78.42       0            28380.77

If you want to save the most interest apply the $3,000 to the mortgage which has a higher interest rate.

The math is simple, at the beginning of each month the bank calculates the interest based on the outstanding principal based on a method referred to as amortization, this means your payment will always be the same but the amount that is interest and principal changes based on the outstanding principal at the beginning of the month. The lower the balance the lower the interest charged; since you are multiplying the interest rate by the outstanding principal it makes sense to reduce the balance on the highest rate loan.

So your 2 choices are apply your extra $3,000 to your mortgage with $130,500 balance @ 3.99% or your $27,000 HELOC at 2.99%.

If you pay down the mortgage you will reduce the next monthís interest from the expected $547.11 to $537.13 a savings of $9.98. I was able to determine you had a $231,590 mortgage and are either 91 or 92 payments into it.

For the home equity loan (HEL) the numbers donít work out as easily so a rough estimate of savings would be assuming it was your first payment on a HEL, if the balance was $27,000 the interest would be $67.28 if you pay it down by $3,000 to $24,000 the interest would be $59.80 a savings of $7.48.

You save an additional $2.50 in interest by paying down the mortgage instead of the HEL.

Each month the math would compound. I don't have time now, but I can publish the spreadsheets to show the math later if you are interested. Also if you have more detailed info on your loans, start date and initial balances I can plug them into the spreadsheet, you can then extrapolate the savings for the duration of the loans.

-Mister FancyPants

zachd

  • Stubble
  • **
  • Posts: 102
Re: Question about paying off debt - 1st ver 2nd
« Reply #11 on: April 17, 2014, 09:47:25 AM »

Sure, a spreadsheet where I could see the difference paying towards one or the other would be ideal. As mentioned though I'm not sure how to calculate the HEL, there is no term, the payment is 1% of the balance each month.  I suppose for the sake of a spreadsheet a term could be made up like 5 years.

The MS spreadsheet posted above will only let you add an extra payment to all months, and you have to start at the 1st month of the loan so it won't tell me exactly what I'm trying to find out but thanks for posting links those might be handy yet.


Mister Fancypants

  • Bristles
  • ***
  • Posts: 296
  • Age: 42
  • Location: New York
Re: Question about paying off debt - 1st ver 2nd
« Reply #12 on: April 17, 2014, 10:04:58 AM »

Sure, a spreadsheet where I could see the difference paying towards one or the other would be ideal. As mentioned though I'm not sure how to calculate the HEL, there is no term, the payment is 1% of the balance each month.  I suppose for the sake of a spreadsheet a term could be made up like 5 years.

The MS spreadsheet posted above will only let you add an extra payment to all months, and you have to start at the 1st month of the loan so it won't tell me exactly what I'm trying to find out but thanks for posting links those might be handy yet.



1% balance how the payment is calculated you said... I still don't know your starts dates and start balances so you will have to adjust yourself accordingly. I will post a spreadsheet in another post.

marblejane

  • Bristles
  • ***
  • Posts: 357
  • Location: SF Bay Area
Re: Question about paying off debt - 1st ver 2nd
« Reply #13 on: April 17, 2014, 10:15:25 AM »
You can just use this free Excel template to calculate the interest savings and time to pay off: http://www.vertex42.com/Calculators/debt-reduction-calculator.html

It's a pretty handy way to compare payoff strategies.

Mister Fancypants

  • Bristles
  • ***
  • Posts: 296
  • Age: 42
  • Location: New York
Re: Question about paying off debt - 1st ver 2nd
« Reply #14 on: April 17, 2014, 10:43:13 AM »
@zachd - I have attached a spreadsheet with 2 worksheets the first title "Mortgage" has a starting balance on $231,590 a term of 20 years and a rate of 3.99% I used the start date of 4/1/2014.

The second is titled "HELOC" the number of years is irrelevant in this sheet it will not change the monthly structure it is a simple interest loan that calculates interest based on outstanding principal and assumes a 1% monthly payment based on balance, at some point a balloon payment for your balance will be due, that is outside of the scope of the comparison so there are will always be 360 payments shown as this was based on the mortgage amortization spreadsheet which I modified for your needs. This loan has a starting balance of $27,000 and a rate of 2.99% I also used a start date of 4/1/2014.

Adjust the values accordingly to match you loans and then for any given month you can add an extra payment and see how it impacts that month and every month thereafter. Continue adding monthly extra payments and see how the compounding takes effect.

Let me know if you have any questions, good luck with your debt reduction strategy.

-Mister FancyPants

MDM

  • Walrus Stache
  • *******
  • Posts: 9495
Re: Question about paying off debt - 1st ver 2nd
« Reply #15 on: April 17, 2014, 02:18:19 PM »
The MS spreadsheet posted above will only let you add an extra payment to all months, and you have to start at the 1st month of the loan so it won't tell me exactly what I'm trying to find out but thanks for posting links those might be handy yet.

The above is true if and only if you use the "Optional extra payments" cell for data entry.  You can ignore that, and instead enter whatever you want in the "Extra Payment" column for any given month.

zachd

  • Stubble
  • **
  • Posts: 102
Re: Question about paying off debt - 1st ver 2nd
« Reply #16 on: April 17, 2014, 02:32:22 PM »

Thanks, I will check out the spreadsheet that was attached and do some comparisons and reply back to thread later on.

warfreak2

  • Handlebar Stache
  • *****
  • Posts: 1140
  • Location: UK
    • Music by me
Re: Question about paying off debt - 1st ver 2nd
« Reply #17 on: April 19, 2014, 05:33:16 AM »
You can show this with a spreadsheet but it's really very simple and intuitive.

If you were to owe another $1000 today, would you prefer to owe it at 3% or 2%? Obviously, you should choose 2%, and pay $20 interest this year instead of $30.

If you could, would you transfer $1000 from a 3% loan to a 2% loan? Obviously, you should, it's the same proposition: you will owe that $1000 at 2% instead of at 3%.

So if you have $1000 cash and you are about pay it towards the 2% loan, now is your opportunity to transfer $1000 from the 3% loan to the 2% loan. Simply pay it towards the 3% loan instead. Comparing the two outcomes, what you did is transfer $1000 of 3% debt to $1000 of 2% debt. So, obviously you should.

None of this is in reference to the size of the loan. If the 2% loan is for $10,000 and the 3% loan is for $1,000,000, it doesn't matter: your decision when you have $1000 cash to make a payment is not a decision about $10,000 or $1,000,000, it's a decision about what interest rate you prefer on that $1000. It's the same proposition, with the same obvious answer: it's better to owe that $1000 at a lower interest rate, so pay off the higher one.

SweetLife

  • Bristles
  • ***
  • Posts: 331
  • Location: Ontario
Re: Question about paying off debt - 1st ver 2nd
« Reply #18 on: April 19, 2014, 11:31:10 AM »
@zachd - I have attached a spreadsheet with 2 worksheets the first title "Mortgage" has a starting balance on $231,590 a term of 20 years and a rate of 3.99% I used the start date of 4/1/2014.

Adjust the values accordingly to match you loans and then for any given month you can add an extra payment and see how it impacts that month and every month thereafter. Continue adding monthly extra payments and see how the compounding takes effect.

Let me know if you have any questions, good luck with your debt reduction strategy.

-Mister FancyPants


Mister FancyPants you are a GENIUS ... well... at least a 5 starts in my book ... thank you for the super easy to use calculator ... I have been searching the internet for something similar that is easy to use and easy to see the results ... this is PERFECT :)

You are my hero :)

Now I can track my Line of credit and my last credit card and my mortgage all in easy to read/use spreadsheet :) Excellent you added the option of extra payments (which I tend try and do) :)

Thank you thank you thank you!!!!

zachd

  • Stubble
  • **
  • Posts: 102
Re: Question about paying off debt - 1st ver 2nd
« Reply #19 on: April 19, 2014, 02:14:10 PM »
You can show this with a spreadsheet but it's really very simple and intuitive.

If you were to owe another $1000 today, would you prefer to owe it at 3% or 2%? Obviously, you should choose 2%, and pay $20 interest this year instead of $30.

If you could, would you transfer $1000 from a 3% loan to a 2% loan? Obviously, you should, it's the same proposition: you will owe that $1000 at 2% instead of at 3%.

So if you have $1000 cash and you are about pay it towards the 2% loan, now is your opportunity to transfer $1000 from the 3% loan to the 2% loan. Simply pay it towards the 3% loan instead. Comparing the two outcomes, what you did is transfer $1000 of 3% debt to $1000 of 2% debt. So, obviously you should.

None of this is in reference to the size of the loan. If the 2% loan is for $10,000 and the 3% loan is for $1,000,000, it doesn't matter: your decision when you have $1000 cash to make a payment is not a decision about $10,000 or $1,000,000, it's a decision about what interest rate you prefer on that $1000. It's the same proposition, with the same obvious answer: it's better to owe that $1000 at a lower interest rate, so pay off the higher one.


Thanks, I do  understand how interest works :)

I need a spreadsheet because there is risk paying my mortgage before my other debt.  Once I pay extra to principal (of the mortgage), I'm not going to get it back until the home is paid off and sold.  With the HEL, if I pay it down to zero, then I have a 40K safety net should I need it.  So I'm trying to determine just how much I will save paying to it first in order to know if the benefit outways the risk involved. 

A payment can be calculated with the formula where P is principal, n are number of payments, and r is interest rate.
A = P * (r*(1+r)^n\ (1+r)^n-1

I wasn't able to use this for the HELOC though because there is no n and the payments are always 1% of the principal.

The good Mr. Fancypants seems to have figured it out for the second tab of the spreadsheet because it seems to match with my payments and now I can make comparisons between the two - thanks!

Even once I know the numbers it's still going to be tough to do. Tougher than I thought to actually go on there and click "submit', I tried it once already :)






warfreak2

  • Handlebar Stache
  • *****
  • Posts: 1140
  • Location: UK
    • Music by me
Re: Question about paying off debt - 1st ver 2nd
« Reply #20 on: April 20, 2014, 03:01:14 AM »
Thanks, I do  understand how interest works :)
:>

I think it's good to have both intuitive and analytical ways to understand things.

Also, someone else suggested that by paying off the smaller one first, you would be able to make bigger payments towards the larger one. I was more responding to that.