How to choose the term on my new loan, considering my other loans.

October 23, 2015 8:07 AM

Financial-advice-filter. I am about to pick up a auto loan and I have a few choices re: rates and term length. Before we get in to numbers, I'm trying to determine what term of loan to take on the lower-interest loan to maximize my money, assuming the same amount of money put aside by me. Thanks for reading!

I have the budget of $637 a month set aside either way to pay off both of these debts, and I'm trying to maximize that money across these two loans.

Auto Loan Details:

Principle: $13,200 (beginning November 2015)
Option 1: 48 months, 2.64 interest rate, payment of $290.08/month
Option 2: 60 months, 2.74 interest rate, payment of $235.66/month
Option 3: 72 months, 3.24 interest rate, payment of $201.98/month
Option 4: 84 months, 3.84 interest rate, payment of $179.46/month.

Student Loan Details:

Principle: $26,634 (as of November 2015)(Deferred min payment until January 2018 - when that starts my rate will be $30,206)
120 months, 6.8% interest rate, (after deferment period) payment of $347.62/month.

So, with my consistent amount of capital of $637 a month, which option for an auto loan should I choose? I know that any leftover capital after my auto loan I should put toward my student loan. (so, with the $179.46 payment, I would put the remaining against student loans, even though the student loan is deferred). I'm having a lot of trouble with all of the moving parts and the financial calculators, especially with dealing with the deferment and the different options. Also, I would be fine (happy) to pay both of these down with additional payments if that wasn't clear. My last car loan I payed off in 32 months despite being a 60 month term.

If this is something I should talk to a financial manager about, that's fine too! I'm not really sure how to find a financial manager, but if that's what you guys think, that would be fine too. Thanks you so much for reading!

posted by bbqturtle to Work & Money (14 answers total)

There's two money philosophies that are really common.

First philosophy, pay off the smaller balance aggressively and then put all the money going into that balance into the larger balance.

The second philosophy is to pay aggressively on the larger balance in order to reduce the amount of interest you inevitably pay on that balance.

My personal suggestion would be to do Option 1 with philosophy 1, and pay off your car loan if possible before you absolutely have to start paying your student loans. Then you can throw all $637 at the student loan every month, and you get the mental boost of paying off the car. But I think that the second philosophy is equally valid; you may have to actually do the calculations to see which one would save you more in the long run. I don't think you actually need a money manager to figure it out.
posted by possibilityleft at 8:44 AM on October 23, 2015 [1 favorite]

Response by poster: I'm definitely in the second philosphy and want to reduce the interest as much as possible. I mentally aggregate all debt into one big lump, so it doesn't impact me either way which loan gets my money.
posted by bbqturtle at 8:58 AM on October 23, 2015

Going off what possibilityleft said, I think it's worth pointing out that "philosophy 1" is only beneficial in the psychological sense of letting you pay off one loan. Philosophy 2, of always throwing the most money at the loan with the highest interest rate, saves more money. If the psychological benefits are important for you - if, e.g. you have poor financial self-control and think a more immediate goal would help you stick to a budget - you should definitely do that. But my sense is, since you've laid this out so thoroughly and thought through the options, that keeping to a budget and doing the most financially sound thing is not hard for you. In which case, you should do the most financially sound thing, which is Option 4. In fact, if possible you should be throwing money at your student loans even before the mandatory payment start - is that an option?
posted by goodnight to the rock n roll era at 8:59 AM on October 23, 2015 [1 favorite]

Response by poster: Sorry to thread sit -

Option 4 is a little counterintuitive to me because the total amount of money spent on option 4 is greater than on option 1 for just the auto loan, and also the term is longer. Do you think you could tell me your reasoning for the choice of option 4?
posted by bbqturtle at 9:03 AM on October 23, 2015

Cool, should have previewed but it sounds like you're on board. Another thing to note is that your budget for this Is clearly just the sun of the minimums of option 1 and the student loans. It might make sense to take a bit of a harder look at your actual budget and see if there isn't some more money you can put each month toward student loans.
posted by goodnight to the rock n roll era at 9:04 AM on October 23, 2015

Sure. You should think about paying off loans as basically a guaranteed investment of that interest rate. So, we can compare the options at least heuristically by just multiplying the amount you'd pay each month toward each by the respective rate you're getting, to find out how much interest you "earn" each month. This gives:

Option 1: 23.6 + 7.65 = 31.25
Option 2: 27.34 + 6.44 = 33.78
Option 3: 29.65 + 7.52 = 37.17
Option 4: 31.14 + 6.87 = 38.01

So option 4 is the best.
posted by goodnight to the rock n roll era at 9:14 AM on October 23, 2015

I’m a nurse, but before I was a nurse I was a finance major, and this is pretty easy to figure out.

It costs you more to borrow the student loan money, so you should pay that as quickly as you can, forgoing the deferment period if at all possible, because it’s going to cost you about $3,400 to defer. (We could do a future value calculation on that sum, but it doesn’t matter for this purpose.)

With the 48-month auto loan, you’re borrowing a total of $14,706, and with the 84-month loan you’re borrowing $17,264, for a difference of about $2,260.

Since interest rates are so low right now, it’s best for you to skip deferment, do the 84-month term of your auto loan, and pay as much as you can toward the student loans. You should also keep in mind that your income will probably increase over time, so you can pay more as you go.
posted by lambchop1 at 9:16 AM on October 23, 2015

The way I would approach this is with a spreadsheet. Google Spreadsheets has a lot of sample templates that handle loan repayments, including having a field for "additional principal payment". So basically, you plug in your starting principal, interest and term at the top, and every row below is a month -- it is a vertical timeline, essentially, so side-by-side with your auto loan, 27 months or so in the future, your student loan payments would appear as well in a set of columns off to the side.

So you can do a series of versions ("duplicate tab" is your friend!) that test each of these scenarios, and the way to evaluate each one is to sum up the "interest" column for all of your loans, and pick whichever version is lowest (since you stated that as your criteria).

Hopefully this makes sense without building a whole sample spreadsheet? I find this much more intuitive than a web-based "payoff calculator" since it is live -- I can type in some additional payments and watch the results change, plus it allows you to see the combined effects of multiple loans all in one place. But it does require that you have a deep love of spreadsheets, which you may not have as strongly as I do :)
posted by misterbrandt at 9:24 AM on October 23, 2015

lambchop1 is right that the student loan is costing you more (about 6% p.a. over the next 26 months) and if it is at all possible to not defer, then pay as much as you can towards that.

Even if you student loan interest is tax deductible, you would need to have marginal tax rate in excess of 40% to make them equivalent.
posted by TORunner at 10:13 AM on October 23, 2015

You will save the most money by paying off the highest interest rates first. You can do the math to verify that by assuming a minimum payment on the auto loan and using the difference as the payment on the student loan.

With that payment, you can solve for the term (or "number of periods") with a spreadsheet or financial calculator.

Multiply that period by the payment and you'll have the total payments, AKA how much money actually came out of your pocket. Add that to the total of payments from the auto loan and option 4 will be the smallest amount.

Option 1: $48,980.71
Option 2: $47,641.71
Option 3: $47,345.09
Option 4: $47,485.24

I've made a couple of simplifying assumptions, one of which explains why option 4 is getting the higher number here:
1. Even though you're in deferment on the student loans, you're going to put the balance of your $637/month towards it starting right now. The more you can do now to reduce the principle balance on your loan, the less you'll have paid in interest at the end.

2. That once the student loans are paid off, you'll keep making the minimum payment on the auto loan.

Option 4 gets the student loan term down to about 71 months. So on month 72, you'd actually start paying $637/month on the auto loan and I haven't done the math to see how that would affect the total of the payments.

The other end of this is how it could affect your cash-flow. Option 4 leaves you with the smallest required payment so if something unforeseen happens and you need a bit of extra cash one month, you have the option of simply not paying the whole $637/month towards your debt.

Lastly, I'd urge you to reconsider how you're managing your budget. Setting yourself a hard number like that is great, it totally works and you will find success that way. However, it can give you permission to spend frivolously. If you have fewer expenses than you've budgeted for one month, maybe you could swing putting $800 towards your debt this month. Instead, some people will take the extra $163 and blow it on "booze and hookers" (the term we use around here to denote conscience frivolous spending) instead.

What I suggest instead is that on the first day of the month, you transfer money in or out to get your checking account balance to about one-month's expenses. At the end of the month, do the same thing. You should pretty much always be transferring money out and those funds should be put towards your debt now and into savings/investment accounts once the debt is paid off.

For now, you should be putting basically all of your extra money towards your debts. Once you're at a point where the rates on all of your debts is less than 3.5% (the historical rate of inflation) you can work on building up your savings. Right now, you just need enough savings for emergencies since no savings account is going to pay you a higher rate of interest than you're paying on your debt. So, if you lost your source of income, how much money would you need to get by until you could either safely and smartly borrow money or get a new source of income. For me, that was only three-months expenses and I included my checking account in that balance but you'll need to figure out what you're comfortable with given that my risk tolerance is a little higher than most.
posted by VTX at 10:21 AM on October 23, 2015 [1 favorite]

There's a wonderful tool here at "unbury me" that can model and project your payments and total interest paid with the same calculations and options suggested already in this thread.
posted by Karaage at 10:47 AM on October 23, 2015 [1 favorite]

Clearly focusing on the student loan, which has a higher principal and a higher interest rate, is going to save you the most money in the long run. If you go for a longer car loan you'll end up paying more in total, but you'll save more than that in student loan interest you won't have to pay.

I think the other thing to think about, though, is what happens if for some reason you can't keep the car for the full length of its loan--if it's totaled or you need to sell it for some reason. Cars start to depreciate pretty much the instant you take possession of them, so that you will almost certainly be upside down on the loan (i.e., owe more than you can sell it for) for some portion of the time that you have it. IF you have to get rid of the car but you owe more than you can get for it from insurance or from selling it, you'll need to make up the difference in the loan somehow. Taking a longer-term loan will extend this upside down period because you'll be paying off the principal more slowly. You can hedge against this by having enough savings to make up the difference or by having insurance that will cover a replacement car if yours is totaled, but you'll pay extra for that in opportunity costs (not using the money in savings to cover debt) or in higher insurance costs. Or maybe you just gamble that there won't be a problem. But you should factor that possibility into your decision as well.
posted by The Elusive Architeuthis at 11:57 AM on October 23, 2015

Do you really need to spend so much money on the car? Neither my husband nor I had any debt and we still chose to spend a lot less money on a car -- around $6500 for a used Honda Fit which we paid immediately. With so much debt for student loans, it seems a bit nuts to me to spend so much on a car, even if you could "afford" it in terms of monthly payments.
posted by peacheater at 1:04 PM on October 23, 2015 [3 favorites]

If Karaage's link isn't working for you, try unbury.us instead.
posted by VTX at 2:21 PM on October 24, 2015