27 Apr Which Loan Do I Pay Off First?
Last week, I was reviewing CashMap’s line of credit strategy with a client. I had just finished coaching them through the process of shopping for a line of credit. As is almost always the case, the credit union representative did not know the billing cycle for their company’s line of credit. It’s understandable. Few people have learned the power of using a line of credit to build wealth. When we finished, the client turned to me and asked, “By the way, which of my loans should I pay off first?”
Prioritize by the Greatest Savings
What a great question. You want to pay off the loan that will give you the greatest savings. Your savings is based on three factors. First, the interest rate, second, the original length of the loan and third, the time left on the loan. The higher the interest rate the greater your savings. Similarly, the longer the period of time left to pay off your loan the greater your interest savings. Let’s create an example.
Choosing the Loan to Pay Off First
There’s nothing better than a visual example. I created a couple of scenarios that demonstrate my point. To view the scenarios that I’ve created, click on the link Choosing the Loan to Pay Off First.
At the bottom of the page, click on the tab, ‘Student Loan, Auto, Credit Card’. This person has a ten year $32,000 student loan with an interest rate of six percent, a five year $25,000 auto loan at six percent and a credit card with a $10,000 balance requiring a minimum monthly payment of two percent that charges 18 percent interest.
Where Does the $1,500 Payment Go?
If you had $1,500 to apply to one of these loans, which would you loan would you choose? For each loan, I applied the $1,500 payment and calculated our interest savings. For each loan, look at the light blue areas. Under the heading, ‘Payments Skipped’, you’ll see a number that is emboldened.
SOLUTION: In this first example, we save the most when the dollars are applied to the credit card. The savings total $3,474. For the student loan and auto loan our savings will total $1,244 and $380.74.
What Loan Do We Apply $5,000?
Select the tab at the bottom labeled, ‘Student, Mortgage, Credit Card’. We’ve replaced the auto loan with a thirty year $300,000 with an interest rate of 3.75 percent. The current balance $295,000.
SOLUTION: Even though the interest rate is just 3.75 percent, the loan is still relatively early in the payment schedule. Consequently, the interest savings from the mortgage are greater than the interest savings from the credit card. Total mortgage interest savings will be $10,043.
Most Solutions Are Simple
What did I do? I subtracted the amount I’m paying off from the balance. I then totaled the interest payments that I will miss until my loan schedule equals the lower balance. Do this for each loan. The loan with the greatest number is the loan to apply your first withdrawal from your line of credit.
For American homeowners, for a relatively small segment of tax payors, tax savings from your mortgage payments should also be considered. Don’t let this complicate the process. Solutions can be simple.
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