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.
Background
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%
Assumptions:
- 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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Funny, Justin; hubby and I were just discussing this. I guess it depends partly on how tight their situation is and how strong they are in the area of discipline.
If they really needed to free up those monthly pmts, or if they need quick wins in order to help them stay on track, they might want to dump the car pmt and consol. loan first.
But financially, it makes more sense to lower the mortgage first, at least until they get rid of the PMI.
A thought-provoking post, Justin. Thank you!
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It is a rare case where the mortgage rate is superior to the debt rate so I’d put all my efforts on the mortgage to get out of PMI and then look for refinance. Refinance should be lower than the consolidated rate so I’d tackle that next.
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You’re right Pauline. I have a friend who couldn’t refi his home and has an interest rate that is slightly higher than the 5.75%. He can’t find a bank that will refi his house until he has some equity. That’s a great solution.
Interesting scenario. I agree with Pauline: Pay any surplus cash toward the mortgage to get out from under PMI sooner and to save the most interest expense, especially since Bob’s not taking the mortgage interest tax deduction. As a corollary, some self-examination is in order about the money choices that led to the $10k consolidation loan. Does Bob have a history of living beyond his means?
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Thanks Kurt, good point. Maybe I should have explained about Bob’s loan. Bob could be thought of as pretty close to my financial situation if I was unable to refi my mortgage. So I guess we’ll assume that he didn’t have an emergency fund, which is what caused the consumer debt. However, he’s saving up his emergency fund as he’s paying off the debt.
That’s a tough one. I think I agree with Pauline as well
On a side note, if Bob currently has a cash trading account with stocks in it, he can try to convert it into a margin account and then borrow money from that to pay down the mortgage until he can get rid of the PMI or get it refinanced at a lower rate. Margin loan interest rates vary depending on country, it’s 4.25% in Canada, doesn’t matter what your credit score is. Don’t know about the US. Bob can ask his broker for details.
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I’d pay the minimum on the two non-mortgage loans. The 3.3% loan isn’t far off the rate of inflation (at least here in Australia) so I’d pay as little of that as I possibly could. Mathematically it’s correct to pay the highest interest rate, particularly as there is a benefit in avoiding the insurance payment.
If Bob is the sort of person who would benefit from the psychological boost that comes from paying off a smaller loan, then there is some merit in paying the consolidation loan first.
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I would always go for the highest interest rate loan and get rid of that first. The only reason I have is that I always take a really long term approach to money.
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For me it always felt better to start paying off the student loans first but they had an incredibly low interest rate that was locked in, subsidized and awesome terms for repayment.
However, after I did the math and found that the interest rate on my credit card was through the roof I realized my student loans were mostly healthy debt. I quickly worked on paying off my credit card. Getting it back to $0 was an awesome feeling and gave me a lot of financial freedom.
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This is fairly straightforward in my opinion, especially once you mention PMI. Pay the minimum on everything but the mortgage; pay a little bit more on the mortgage.
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I think part of it depends on future stability, as you have alluded to not wanting the monthly payments. Yes, the mortgage is definitely what makes the most sense to pay down. Do you gain flexibility by doing so? We have massively overpaid our mortgage and as a result we can walk in tomorrow and have our payments dropped to a very, very low amount, without having to refinance. Would that help?
I think another aspect is how much extra is available to be thrown at these debts. If it is several hundred dollars per month or a thousand, I would put a portion towards the consolidation loan (reducing monthly liabilities to keep Bob emotionally happy and to reduce cash flow/risk concerns), and a portion toward the mortgage (by far the highest savings, especially with the PMI).
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I would probably pay off the smaller loans first just for the psychological boost but that’s just me. Really, as long as Bob is choosing to pay them all off and stay out of debt it doesn’t really matter that much.
The numbers would say go for the mortgage, but I think I’d knock out that consolidated loan first for morale. It would take a long time to pay off the mortgage and he might get discouraged.
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I personally can’t stand debt, so I would also try and rent out a room to expedite the payoff process. If it’s an expensive car, I would even consider downgrading to something cheaper to try and get rid of the car loan completely. Or, try and make do without a car, and take the bus/train/bike to work. These options might be a little more extreme for some people, but if you really want to get rid of the debt quickly, sometimes you need to take more extreme measures.
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1) Consolidation loan 4.4%
2) Car Payment 3.3%
3) Mortgage 5.75%
I usually go with the interest rate and go highest to lowest with the exception of a mortgage (due to the tax incentives and refinance opportunities).
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No matter how you slice and dice it, debt is debt. You have to find ways to either reduce it to a manageable level or eliminate it altogether.
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