Deciding which debt to pay off first should be a pretty straight forward process. You might pay off the highest interest rate first and work you way to the debt with lower rates. On the other hand, you may choose to pay of the lowest balance first and work your way to the higher balances so that you can get a psychological boost to paying off your debt.
In either case, when most people begin their journey to becoming debt free they place their mortgage debt in a different category and choose to pay it off last. In most circumstances this is a great idea. Currently interest rates are historically low, if you have a stellar credit score you may even score a rate lower than inflation. You may also receive a deduction on your income taxes for the mortgage interest that you pay on your primary residence.
I began to wonder what the best course of action would be if you have multiple debts, but your mortgage carries the highest interest rate and the interest payments are not enough to outweigh using a standard deduction.
You may wonder how exactly could it occur where a person’s mortgage has the highest interest rate. Well here is the scenario. Bob currently has three debts at various interest rates:
- $100,000 Mortgage 5.75%
- $10,000 Consolidation loan 4.4%
- $10,000 Car Payment 3.3%
- The Mortgage has 25 years left. The person will take the standard deduction because itemizing will lead to a lower deduction. If Bob makes the minimum mortgage payment he has to pay PMI (Private Mortgage Insurance) of $350 per year for the next five years.
- Bob currently cannot find a bank willing to refinance his home.
- The consolidation loan and car loan both have 5 years left on them.
- Bob intends on keeping the home. Even if he moves, Bob intends to rent out the house.
These assumptions are pretty specific. However, I wanted to illustrate an example where it might be more prudent to pay off the mortgage first. Obviously what matters is Bob’s goals.
If I were in this situation I might lean towards putting extra money towards the mortgage. But it isn’t that easy. What if cash were tight in Bob’s household and he preferred to pay off the consolidation loan a little faster to reduce monthly payments.
What would you do in this situation? What debt would you pay off first?
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