Author Topic: What order to pay off loans in...  (Read 4803 times)

digger

  • 5 O'Clock Shadow
  • *
  • Posts: 14
  • Age: 2015
  • Location: East Tennessee
  • One step at a time...
What order to pay off loans in...
« on: March 01, 2013, 07:13:49 PM »
So I know I will probably be kicking myself for how simple this is once I get my head around the math... and I used to think math was my strong suit..

Oh well, here goes...

Say I have the following loans
$50000 at 5%
$25000 at 6%

Which one do I attack first? People always say to pay off your highest interest loans first, but in this case it seems like it makes more sense to attack the slightly lower interest rate with the higher balance? Am I missing something here? Also, if I am to attack the higher balance loan, at what point do I switch and attack the higher interest one?
Or am I completely missing the point and should I only be attacking the 6% loan until it's gone?

What would a Mustachian do?

emoore

  • 5 O'Clock Shadow
  • *
  • Posts: 3
Re: What order to pay off loans in...
« Reply #1 on: March 01, 2013, 07:29:57 PM »
Paying off the loan with the highest interest rate first is the best way to go.  You'll pay less interest overall.

Another Reader

  • Magnum Stache
  • ******
  • Posts: 4968
Re: What order to pay off loans in...
« Reply #2 on: March 01, 2013, 07:37:38 PM »
In your shoes, I would pay off the $25k loan first.  It has a higher interest rate and a lower balance.  Make the minimum payments on the $50k at 5 percent and throw everything else at the first one until it is paid off.  Then throw everything at the larger loan with the lower rate.

Zaga

  • Handlebar Stache
  • *****
  • Posts: 2075
  • Age: 39
  • Location: North of Pittsburgh, PA
    • A Wall of Hats
Re: What order to pay off loans in...
« Reply #3 on: March 01, 2013, 08:06:42 PM »
Just look at this logically, the loan you pay off first will be around for a shorter time period.  So you want the one with the higher interest rate to be gone first, right?  Because if you pay it off second then you are paying the higher rate for a longer time.

marty998

  • Walrus Stache
  • *******
  • Posts: 6309
  • Location: Sydney, Oz
Re: What order to pay off loans in...
« Reply #4 on: March 02, 2013, 06:11:47 AM »
Right forgive the long maths post to follow please

I ran the numbers assuming a 10 year term which gives minimum P&I repayments of $277.55 and 530.33 respectively (807.88/mth). This gives total payments over 10 years of $96945.

If you paid interest only on the 25k loan ($125/mth) and paid off the 50k loan first with the remainder ($682.88/mth), then snowball the $807.88 into the 25k loan once the $50k is gone, you pay a total of $97,915

If you paid interest only on the 50k loan ($208.33/mth) , and paid of the $25k loan @ 599.55/mth, then snowball $807.88 into the 50k loan once the $25k is gone, you end up paying a total of $95,879.

So the answer is not much, but it all depends on your term of the loan and you max capacity to pay. The best (though unlikely) answer is to pay off the $75k today.

Another Reader

  • Magnum Stache
  • ******
  • Posts: 4968
Re: What order to pay off loans in...
« Reply #5 on: March 02, 2013, 06:43:28 AM »
The non-math answer is to get as many loans paid off as you can as soon as possible.  If you were to become unemployed or temporarily disabled, it is easier to manage one minimum payment than many.  It's also easier to negotiate with one lender than it is with many.

The present worth of the interest difference is small compared to the flexibility and peace of mind reducing the number of loans affords you.

digger

  • 5 O'Clock Shadow
  • *
  • Posts: 14
  • Age: 2015
  • Location: East Tennessee
  • One step at a time...
Re: What order to pay off loans in...
« Reply #6 on: March 02, 2013, 06:47:15 AM »
Thanks all!

Marty, thank you for breaking it down like that, that's exactly what I was looking for!
It's interesting how close it is at the end of the day. But still clearly better to attack the higher interest loan first.

It makes me wonder if there is ever a "situation" that it would make sense mathematically to pay a loan with a lower interest but higher balance first?

marty998

  • Walrus Stache
  • *******
  • Posts: 6309
  • Location: Sydney, Oz
Re: What order to pay off loans in...
« Reply #7 on: March 03, 2013, 04:09:05 AM »
It depends who you owe money too.

A mortgage with a bank is not going to cause as much issues as a loan from a mobster who may not understand compound interest but certainly knows the value of breaking your legs.

:)

arebelspy

  • Administrator
  • Senior Mustachian
  • *****
  • Posts: 27760
  • Age: -999
  • Location: Traveling the World
Re: What order to pay off loans in...
« Reply #8 on: March 03, 2013, 08:12:46 AM »
Well this thread made it quite easy.

Typically the question is "higher balance with higher rate versus lower balance with lower rate" and followers of the debt snowball advocate for the latter, and they need a punch in the face. 

Higher interest = pay it off first.

It makes me wonder if there is ever a "situation" that it would make sense mathematically to pay a loan with a lower interest but higher balance first?

No.
We are two former teachers who accumulated a bunch of real estate, retired at 29, and now travel the world full time with two kids.
If you want to know more about me, or how we did that, or see lots of pictures, this Business Insider profile tells our story pretty well.
We (rarely) blog at AdventuringAlong.com. Check out our Now page to see what we're up to currently.

SwordGuy

  • Walrus Stache
  • *******
  • Posts: 5332
  • Location: Fayetteville, NC
Re: What order to pay off loans in...
« Reply #9 on: March 03, 2013, 08:47:53 AM »
If your only criteria in deciding which loan to pay off first is to reduce the total interest paid, then it only makes sense to pay off the high interest loans first.

However, there is another measure of financial well being and that's positive cash flow. 

Let's say that you have loans that look like this:
rate balance  payment
8% 50,000    1000
6%   4,000     100
6%   4,000     100
6%   4,000     100
6%   4,000     100
6%   4,000     100
6%   2,000     100
6%   2,000     100
6%   2,000     100
6%   2,000     100

And, let's further assume that you don't have much money in your budget that is free to add extra payments with.  Every month is a nerve-wracking task to make all the payments on time.

You get a tax refund of $4000.  Where do you put it? 

If you put it on two of the $2000 balance loans, you free up $200 a month right away.  Now you have a $200 positive cash flow cushion to use to make life easier.  Not to spend more!  Just to make it easier and stress free to pay the remaining bills.

Which loans do you put the extra $200 you just freed up on?  If you put it on one of the remaining $2000 loans, you'll free up another $100 a month in positive cash flow much sooner than you will if you put it towards the $50000 balance.

At some point you have enough positive cash flow to handle the regular emergencies life throws at you easily.  You know, you need a car repair, or the hot water heater breaks, or some kid spikes your car tire for fun.  In fact, you no longer consider them emergencies at all, just pains in the butt.

To my way of thinking, that's the time to pile on the cash towards the $50,000 balance instead of the smaller loans.   

The traditional Dave Ramsey snowball method is to pay off the smallest loans first.  That's less mathematically efficient than the advice to pay off the highest interest rate first, and also less mathematically efficient than what I propose in the situation above.    The method I suggest for the situation above means you pay more total interest and subject your body and mind to much less stress. 

I'll consider my face punch delivered. :)

Richard3

  • Bristles
  • ***
  • Posts: 292
Re: What order to pay off loans in...
« Reply #10 on: March 03, 2013, 03:39:53 PM »
Quote
It makes me wonder if there is ever a "situation" that it would make sense mathematically to pay a loan with a lower interest but higher balance first?

Yes. If the higher interest rate loan has early repayment penalties / admin fees that wipe out the benefits of paying it back early.

Any plan other than making the most mathematically effective payments (highest reduction in interest paid) is spending money for intangible benefits.


Whether the SwordGuy plan or the Dave Ramsey plan is more mathematically efficient (or rather less inefficient) depends on the balances and interest rates. The monthly payment is a figment, a piece of misdirection ro distract you from how much you are paying in total.

For example you get $2000.

8% 50,000 1000
4% 2000 400
6% 1000 100
12% 1000 50

Maths says pay off the 12% loan and $1000 from the 8%. That saves $120 + $80 in interest and $50 immediate cashflow.

Dave Ramsey says pay off the 12% and the 6%. That saves $120 + $60 in interest and $150 immediate cashflow

SwordGuy says pay off the 4% loan that saves $80 in interest and gives $400 in immediate cashflow.