Which loan should I pay down?

May 12, 2005 12:27 AM

I have two loans, and an extra $250/month to pay them down, but I don't know which one to choose. *Bonus question: should I pay them down?

The first is a student loan with a balance of $14,500 and a variable interest rate of 3.37%, and the second is an auto loan with a balance of $8250 and a fixed interest rate of 4.75%. Both have a $250 minimum monthly payment. I can pay an extra $250/month on top of the combined $500 monthly bill. Which one should I pay down first?

*Bonus: should I be paying the loans down or saving/investing the money? I pay about $40/month in interest for each account (of course, getting smaller every payment). Is there any reasonably safe investment that could beat lowering the interest? This stuff makes my head hurt.

I don't have any "portfolio" other than a two-month savings safety net and three small IRA rollover accounts.

posted by letitrain to work & money (22 comments total)

I'll take the last part first, Jack.

The only investment that has the realistic potential to make more money than you're losing right now on the interest to the loans is real estate, but even then that's a highly speculative roll of the dice. There's no question in my mind that paying off the loans as quickly as possible will earn you a higher 'rate of return' than an investment, especially because investments are, by their very nature, risky (especially high yield ones which could have the potential to beat the rate of the loans), and your loans are a sure thing. That one's a no brainer.

On the other question, there are tax issues at work, here, too, I believe -- talk to an accountant and see if there are any tax benefits to paying off your student loans. Is a percentage of that money deductible? The car loan has no tax potential. If paying off your student loans won't affect your taxes, then I'd say pay off the car loan more. The interest rate is higher, hence it's the more expensive loan. If rates rise on the student loan and it becomes higher than the auto loan, then switch.

Not to preach, but take care of revolving debt (credit cards) before any of this, and then make sure you pay off those cards every month.

But DEFINITELY don't invest the money -- the 'investment' of paying off the loans is as sure a thing as you'll ever encounter, and sure things only come along once in a blue moon.
posted by incessant at 12:54 AM on May 12, 2005

I am going to disagree slightly (but only slightly) with incessant on this. You said you only have two months of a savings safety net. I suggest you move that to a high-interest FDIC-insured savings account with an Internet bank, such as those listed on bankrate.com. The highest rate there has a simple interest rate of 3.25% (3.30% APY if your rate is an APR and you want to compare apples to apples). That is only slightly lower than your student loan rate. I would build up your safety net to six months, then stop saving and pay off the student loan.

After all, if you lose your job or are temporarily disabled and can't get back in the saddle for more than two months, you aren't going to be able to borrow money again at 3.37%. It's the liquidity, not the investment value which is at issue (clearly paying off the loan is the best investment).

But yes, pay the auto loan off before you pay off the student loan. No sense at all in paying off a low interest loan more than the minimum when you have a higher interest loan out as well. It is a little trickier with the auto loan since the rate is slightly higher, but my instinct is that it is more important to have a little more liquid cash than you do.

I'll agree with incessant that high-interest loans like credit cards should be paid off first even if you have zero savings.
posted by grouse at 1:27 AM on May 12, 2005

I'm guessing that if you're paying about $40 a month interest on each loan, the interested rate quoted for the student loan is the APR (Annual Percentage Rate, precisely defined in law by the Truth In Lending Act) but the rate for the auto loan is not. In fact, your APR on the auto loan is probably closer to 6% (rough guess).

Based on these assumptions, you will pay off your student loan entirely in about 2 years 7 months if you put the all of the extra money toward it, and you will pay off the remainder of the autoloan within an additional 3 months if you continue paying $750 per month towards your debt.

If you put the extra money toward the auto loan first, you will pay it off entirely in about 1 year 5 months, and pay off the remainder of the student loan within an additional 1 year and 1 month.

These ROUGH calculations (plus or minus a couple of months and remember the assumption about APRs) are based on the annuity immediate formula which calculates the actuarial present value of future payments.

As for the investing, it is not worth your while if you only have $250 a month to play with. Forget about the risk/return considerations (which aren't great) -- transaction fees on such a small investment will wipe out most of any gains you make.
posted by randomstriker at 2:08 AM on May 12, 2005

One trap for young players though - some (very few nowadays) finance organisations penalise those who pay loans out early, so check that this won't happen first.

Otherwise, always pay out the low interest loan first, all things being equal.
posted by dg at 2:33 AM on May 12, 2005

Otherwise, always pay out the low interest loan first, all things being equal.

I've always been told the complete opposite. Always pay off the highest interest loan first.
posted by PenDevil at 4:28 AM on May 12, 2005

As mentioned -- any "investment" you make must take into account the interest you are paying by not instead paying off debt. At the rates you're paying, this isn't a huge factor, but it isn't a factor.

dg's first remark is very true -- make certain that paying off your auto loan early will actually save you money. If not, there's no reason to do so.

Finally, if you don't have a liquid reserve for trouble, you should consider, instead, putting the extra $250 into that. It sounds impossible, but having 6 months of expenses in the bank can make a huge difference in your life in the future -- it saved me last year when I was out of work for just over a year -- I'm still working on rebuilding the cushion. If that $250 means you are now living month-to-month, then you need to save that, not pay off debt. Better to pay what you owe, and have the ability to pay later, than pay more than what you owe, and then not be able to pay anything later.

And remember to do the victory dance around the car when you do pay it off. ;)
posted by eriko at 4:44 AM on May 12, 2005

dg: That makes no sense, I presume it's just a thinko. Pay the high interest loan before the low interest loan.
posted by grouse at 4:45 AM on May 12, 2005

OK, obviously pay the higher rate loan first, all else equal, but the school loan (is it federal?) is at an adjustable rate. If it's federal, you know how the rate is calculated, right? It's the 91 day T-bill price on May 1 plus 1.7%. And I think that brings it just about up to the same level as your car loan, unless randomstriker is right and your car loan is actually much higher nominally.

In other words, your student loan could go up any time, it IS going up already in fact, just maybe not as much as your car loan yet, so it's unclear which you should pay more rapidly. Any given timeframe where your student loan has a higher rate (it changes annually), you should definitely pay it first.
posted by rkent at 4:59 AM on May 12, 2005

Neither of these loans carries particularly high interest. You do not have a lot of savings. Given that background I would plow the extra $250 into savings to build up a little better safety cushion. From a pure investment standpoint you can probably do slightly better by paying off the car loan. However, I think having a better safety cushion outweighs a few extra dollars in your pocket, and if you run the math it probably will be very few. Of course if your investments pay better than the car loan than investing puts more $ in your pocket.
posted by caddis at 5:00 AM on May 12, 2005

I'm going to take a slightly contrarian point of view here.

I spent fifteen years in debt (often deep in debt), and only recently have been able to shed most of my liabilities. I did it in very short time by ignoring the common "pay the highest interest rate first" advice. Yes, this makes the most financial sense in theory; in reality, for some of us it never works.

What worked for me was to pay off the debt with the lowest balance first. When I had paid this off, I took the money I would have spent on this each month and applied it to the next lowest balance. When this was paid off, I took the combined savings and applied it to the next lowest balance. This "debt snowball" worked amazingly well. Things went damn fast.

After a decade of trying to pay off high interest rates first, it only took siz months to get rid of all my debt with the lowest balances first approach.

So, yes: in theory, it's best to pay off your highest ineterest rate items first. In reality, it may not be the best choice.

(Self-link: for more on my approach, check out my weblog entry: get rich slowly.)

Much of the advice in this thread is good in theory. I've found, however, it's best to do whatever works for you.

For example, while it's ideal to accumulate an emergency fund, if, like me, you don't have the discipline to leave that money untouched, then by all means pay off your debts first. And, as I already mentioned, if, like me, you find the psychological boost of paying off something (anything!) more incentive than saving a few bucks by paying off higher interest loans, then pay off the low balances first.

Please don't just dismiss my advice. I wish that somebody'd told me a decade ago that it was okay to ignore the "pay the highest interest rate first" crowd. I might have dug my way out of debt sooner. (And I really wish I'd never signed up for that first credit card way back in college.)
posted by jdroth at 5:56 AM on May 12, 2005

As someone just coming off a quasi-unplanned three month period of unemployment, who is also paying off a student loan of $14,000, I thank my earlier common sense to have put aside enough money as a safety cushion. I'd have been begging without it.

You can always split it up and put $200 towards the safety cushion, and the remaining $50 to one of the loans (or any other combination). In the long run it might shorten your loan by a few months, all the better.
posted by furtive at 6:02 AM on May 12, 2005

Oh, and once your safety cushion is equal to what you'd need to get by for about two months, then you can start putting the rest towards your loans.
posted by furtive at 6:06 AM on May 12, 2005

I would recommend paying off the car loan first (whether you decide to split some into savings or not - which is a good idea). If you lose your job, you can negotiate with the student loan holder to get a temporary deferment. You usually cannot do the same with a car loan provider.

Also, the interest on your student loan is lower than what you listed by the sheer fact that you get a tax credit for paying interest on student loans. Again, you won't get this with a car loan.
posted by blackkar at 6:46 AM on May 12, 2005

To follow up on a few points: yes, the interest paid on the student loans is deductible. I think it's actually taken right off the tax, not off the taxable income (a tax credit?). I have no revolving debt - my one credit card is paid off every month. There are no penalties on either account for paying early.

Based on the excellent advice above, I think I'm going to:

a. transfer the savings to an high-interest internet bank and build it up to six month's expenses, then

b. pay down the auto loan until it's gone, then

c. pay down the student loan.
posted by letitrain at 8:14 AM on May 12, 2005

I think it's actually taken right off the tax, not off the taxable income (a tax credit?).

No, you were right the first time, it's a deduction, not a credit. So the money you pay towards student loan interest is deducted on the first page of the 1040, and it is not counted as income when your tax is calculated.

This is a great thread. I just chopped a thousand a year off my auto insurance and was wondering where I should usefully apply the extra cash.
posted by Kellydamnit at 8:31 AM on May 12, 2005

As ancillary advice about savings accounts, make sure the account is FDIC or NCUA insured. Also, some banks will give you premiums for signing up. UFB Direct will give you some AAdvantage miles if you jump through the right hoops, and ING Direct will give you $25 if you get a referral from a current user.

If you are worried about discipline, most of these accounts can set up a direct deposit to take that $250 out of your savings before you even notice it being there.
posted by grouse at 8:48 AM on May 12, 2005

out of your savings checking
posted by grouse at 8:50 AM on May 12, 2005

Bankrate (I don't know how I missed this great website - thanks grouse) has a debt pay down calculator that directly answers my first question, based on interest rates, tax concerns, etc. It even creates a custom accelerated payment plan that you can print out.
posted by letitrain at 9:40 AM on May 12, 2005

I'm guessing that if you're paying about $40 a month interest on each loan, the interested rate quoted for the student loan is the APR (Annual Percentage Rate, precisely defined in law by the Truth In Lending Act) but the rate for the auto loan is not. In fact, your APR on the auto loan is probably closer to 6% (rough guess).

randomstriker: good catch. I went back and checked the interest paid on the auto loan, and it was $33 last month. I rounded wrong, but the 4.75% APR is correct. Oh, and the formula you linked makes me want to crawl into a fetal position and make the bad numbers go away!
posted by letitrain at 12:04 PM on May 12, 2005

jdroth: that's an excellent blog entry you've written. I've skimmed it and printed it out to read in its entirety later.

Thanks all!
posted by letitrain at 12:12 PM on May 12, 2005

dg: That makes no sense, I presume it's just a thinko. Pay the high interest loan before the low interest loan.
D'oh! Of course, that is what I meant. Stupid ape-brain.
posted by dg at 3:04 PM on May 12, 2005

No matter what you do, consolidating your student loan to a fixed rate is probably a very good idea. New interest rates for federal loans kick in July 1, and they will probably be higher. Locking in a low rate is probably a very good idea.
posted by zsazsa at 3:25 PM on May 12, 2005