How is $50k spent in the best possible way among a several debts and a paltry savings?

October 17, 2005 10:24 PM

Say you come into $50k out of the blue. What's the best thing you can do with it, financially speaking, when you have a couple mortgages, some minor debt, small savings, and even smaller retirement? Which to attack first?

Things that the money could go towards:
1. About $50k of a second house mortgage currently at prime rate plus 1%
2. About $25k total of car loans plus school loans (no credit card debt of any kind)
3. Savings usually hovers between $5k and 10k
4. Lifetime of retirement savings into 401k is probably $25k so far (I just turned 30).

I'm curious if I should pay off my car/school debts and continue paying down a mortgage that gives me tax-deductible interest (the car and school loans don't), should I continue paying all debts and invest it hoping to exceed any interest on debts (average interest on car/school debt is only about 5%), put some into IRAs, or do I do a mixture of any of the above?

My gut feeling is that while I should pay off my second mortgage and own a full 20% of my home, it seems like I could take better advantage of some tax breaks doing other things.

posted by anonymous to work & money (18 comments total)

I would pay off the highest interest rate loans first, after that I would pay off anything that will depreciate over time rather than appreciate (cars over houses). I would also put the max into my IRA and any other possible tax free/ deferred savings for the year. If you don't have it, give youself that mythical 6 month cushion in cash before you pay off your mortgage. And investigate early payment penalties on your various loans before making any decisions.

Probably the best thing is to talk to a financial specialist though, instead of a bunch of jokers on the internet.
posted by fshgrl at 10:34 PM on October 17, 2005

Probably the best thing is to talk to a financial specialist though, instead of a bunch of jokers on the internet.

I'll agree with that sentiment. It'll cost you a little, but it sounds like you just came across $50k. It'll probably end up saving you quite a bit more.

But, just to throw my opinion out there, I'll go ahead and echo the idea of paying off high interest loans first, things that depreciate fastest next. Of course, depending on where you live, paying off the car first might be the best bet... If you've taken a loan out to pay for it I'm guessing you have collision insurance, which can cost you through the nose if you've got a bad driving record, a kid that's about 16, or if you live in the wrong zip code. Of course, if you would opt for collision insurance, even without the loan, ignore this advice.
posted by dsword at 10:59 PM on October 17, 2005

Is the interest payment on the car loans based on a fixed rate? I would assume so. If you believe interest rates are going to continue to rise, you may think about paying off the mortgage since it is has a floating interest rate rather than paying off the car loan. The mortgage rate at prime + 1 is already more expensive than the car/school loans and it wouldn't take much of an increase in rates for it to be more expensive even with the deduction (since you can only deduct interest, the deduction will also start shrinking).

If you invest, you can only put so much in an IRA per year. If you end up paying taxes on your gains, you'll be hard-press to beat the savings you'll get by paying down the prime + 1 debt.

I don't have enough information to do it, but you could figure out the savings/earning on each of your options over time and calculate a net present value. You'd discount the cash flows on the tax savings at relatively low rate while the discount rate on the investment options should be greater depending on the risk inherent in your investment choice (e.g. if you put it all in tech stocks you'll use a lot higher rate than if you bought utility stocks).
posted by mullacc at 11:02 PM on October 17, 2005

I asked a very very similar question here. The answers there may help.
posted by stavrosthewonderchicken at 11:28 PM on October 17, 2005

Free yourself from debts first, I think, then mortgage, loans and such.
posted by XiBe at 2:13 AM on October 18, 2005

If you free yourself from debt first you will likely just start accumulating debt all over again and still have no savings. Put the money away in some form of investment, say stocks and continue paying down your existing debts with your current income. You could theoretically do better by paying off the debts and then taking the extra money each month from not having to make debt payments and investing that. However, human nature is tough here and most of us have a hard time not just spending the extra cash on current needs and wants. Perhaps a direct withdrawal stock purchase plan might work though, where money is automatically taken each month from your checking account to buy stocks (usually a mutual fund). Since the mortgages are tax preferenced I wouldn't touch those, regardless of which course you decide.
posted by caddis at 4:27 AM on October 18, 2005

You obviously are on a pretty good track, financially. No credit card debt, savings, a house. I'd agree with paying off the car, school loan and anything that is not tax-deductible. The tax break on mortgage interest is a pretty good deal. You are probably disciplined enough to put the money you save on the car and school loans over the next 3 - 5 years into a 401k and other savings. I'd max out any employer-sponsored pension contribution. Your employer might have a pre-tax contribution option, for an extra bonus. Early savings really get the chance to grow.

On the mortgage, you need to know your marginal tax rate. The tax savings on the 2nd mortgage may make the effective rate pretty low.

And take a couple thousand and take a vacation or buy a great piece of art or some other soul-satisfying splurge.
posted by theora55 at 6:33 AM on October 18, 2005

Pay off your highest interest loan. The key to success here is that if/when that loan is paid off you use the money that you were using for that payment on your next loan.

You've got a great opportunity to increase your fiscal discipline.

If you invest or save the money, if you get a lower rate of return then you are paying in interest, you aren't helping yourself much.
posted by ewkpates at 6:51 AM on October 18, 2005

Given what you state above, were I in your situation, I would first determine my tax liability on the amount. Once I place enough aside to deal with that, I would, in order of priority, eliminate my debt, make sure I had six months' income stashed in an accessible yet interest-bearing account (I don't know what mechanisms to use to maximize the interest), give $500 to my food bank and $500 to hurricane relief, and put the remainder in my 401(k).
posted by WCityMike at 7:27 AM on October 18, 2005

Several people have said you're on the right track. I wonder. This sequence concerns me:

1. About $50k of a second house mortgage currently at prime rate plus 1%
2. About $25k total of car loans plus school loans (no credit card debt of any kind)
3. Savings usually hovers between $5k and 10k
4. Lifetime of retirement savings into 401k is probably $25k so far (I just turned 30).

The "no credit card debt" isn't impressive if it's because you took a second mortgage to pay it all off and you just haven't run it back up. Which I certainly hope you don't do, but the sad fact is the majority of people who take consolidation loans do just that.

I'd say you have a savings problem and you should address that more than anything else. With two mortgages I'd assume that savings won't cover the combined payments for too long if you found yourself unable to work, putting you one work-stopping injury from homelessness.

I'd suggest:

1. Buying yourself some disability coverage if your employer doesn't provide any. It should be reasonably cheap. Life insurance too, but only if you have a spouse or kids - otherwise it's a waste of money.
   
2. Make the maximum IRA contribution for this year, unless you have a 401k you can contribute to, in which case you should max that out.
   
3. Putting the rest in a reasonably accessable savings program. I'm sure there's options superior to ING Direct's 3 point something program out there. The key is being able to get to it in a reasonably short period of time if you have an emergency of some sort.
   

posted by phearlez at 7:57 AM on October 18, 2005

Even if the entire mortgage payment was tax deductible (which it isn't, unless the payments are interest only) and anonymous was taxed only in the highest bracket (which s/he isn't), the effective rate on the mortgage would be 4.65% (6.75% + 1% = 7.75% * (1-39%) = 4.72%). So the best case scenario is that the mortgage payment is 28 basis points cheaper than the 5% average cost of the car/student loans. Since the mix of interest to principal payments will decrease over time and the actual tax rate is probably lower AND interest rates are likely to rise, I'd say it's pretty safe to assume that the mortgage payments are more expensive than the other debts.
posted by mullacc at 8:10 AM on October 18, 2005

phearlez, I believe anonymous probably purchased his home with less than a 20% down payment ("My gut feeling is that while I should pay off my second mortgage and own a full 20% of my home") so the second mortgage is probably from an 80-10-10 or 80-15-15 financing program.

Anyhow, I agree with caddis and phearlez about investing the bulk of this money instead of using it in toto to pay off debts. But I would also second the advice of seeing a fee-based financial planner to explore your options.

Look at it this way. If your car loan is stretched out over four years at 5%, you'll pay about $2,600 over the life of the loan in interest.

Now if you were to invest that $25k for four years instead, you'd need a rate of return of about 3% to "beat" the amount of interest you'll pay on the car loan. Assuming that you'll be holding that investment for many years, through compound interest I think you would eventually come out far, far ahead.

I would recommend paying off the debts though is you are struggling to make payments on time and getting into credit debt. But that really doesn't sound like your situation.
posted by Sully6 at 8:18 AM on October 18, 2005

Do the math. Which of the loans is costing you the most in interest over the long term. Be sure to add in any early payment penalties. Whichever costs you the most over the long term, pay that one off.
posted by Pollomacho at 8:34 AM on October 18, 2005

I don't agree with the 3% target rate of return on an investment. If anonymous keeps the car loan, s/he will pay about $2,635 in interest over four years and if I discount that at a 4% rate, I come to a present value of $2,473. At the end of 4 years, the 3% investment will have compound to $28,138 for a gain of $3,138. There are many ways to tax that, but if I assume the best scenario of 20% deferred capital gains tax the net is $2,667, discounted back at 4% to $2,280. So my net present value is -$193.

If you just pay off the car loan, your net present value is $2,473. In order to beat that, you'd need a return of something around 6.3%. I'd argue that you'd have to go even higher because a discount rate of 4% is too low for an investment with an expected return of 6%+.

And if you wanted to beat the interest savings on the mortgage, you'd have to find even higher returns because the mortgage is probably more expensive.
posted by mullacc at 9:26 AM on October 18, 2005

look into the S&P spider funds - ticker symbol = SPY. It's like buying the entire S&P 500, similar to buying into a mutual fund without the suckers who skim an investing fee. I think you'll find the historical return on spiders is more than what you're paying on your outstanding debt, and as mullacc said, you need something more than 6.3%.
posted by masymas at 11:40 AM on October 18, 2005

Be sure to focus not only on debts, but what payments effect your household cash flow. Saving for retirement is important, but at 30, you'll be alot happier each month if you pay off the 2nd mortage and car/school debt and focus that money that you were paying each month on a savings/retirement plan. Pick up any of the David Bach books, I was sceptical at first, but after reading a few, his solutions totally make sense. Good luck!
posted by adamfunman at 11:47 AM on October 18, 2005

Ah yes, mullacc, I neglected the tax burden on investing. I would say that putting the money into a 401K or similar tax-deferred retirement plan would skirt that issue, but I believe the most you can contribute in a year is around $14,000.

At any rate, I wonder if part of the number crunching for Anonymous to do is calculate how long it would take him/her to save up $50,000 to invest. If it's years and years, then part of the calculations, I would think, should include weighing the compounding interest for those years against the money saved on interest by paying the debts off now.

Again, I'll reiterate my advice to a fee-based financial planner who can generate various scenarios for you to guide your decision making.

One last thought about the mortgage: Anonymous could refinance once he/she has 20% equity through appreciation and thus get rid of that higher interest second mortgage, saving some money there--at least monthly. (Of course, taking a 10-year HELOC, which seems typical for the second mortgage in these 80-10-10 deals, and bundling it with a 30-year in a refinance would lower the monthly payment but result in more interest paid over the life of the loan.)
posted by Sully6 at 12:26 PM on October 18, 2005

I would put it into your IRA first absolutely, then your savings. Paying off loans contributes to a good credit score, and you want a long history of good payments. I guess you already have houses and a car, but that's what Suze Orman would say.
posted by scazza at 1:21 PM on October 18, 2005