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The Lesser of Two Evils: Determining Which Loan to Pay off First
The other day I was asked a good question: "We are looking to put some extra money towards prepaying one of two loans, so how would you go about determining which one to pay off?" Like most good questions, there is no easy answer. For most debt repayment questions, I would turn to Dave Ramsey’s debt snowball (pay off the loans in order from smallest balance to highest) or a similar technique (pay off the loans in order from highest interest rate to lowest). But this person was asking a slightly different question.
(Hey, I thought you said that debt wasn’t evil? Well, I did say that , and it isn’t, but that doesn’t mean it is a good thing. Besides, "the lesser of two bads" or "the lesser of two not-so-goods" does not make for nearly as catchy a title!)
The debt snowball and similar techniques assume that the person is paying off all of their loans in order. By rolling over the freed up cash after each loan is paid off into the payment for the next loan, it does not really matter what the balances or interest rates or remaining term of the loans are (depending on which technique you are using, of course) since it all basically works out in the end.
This is not the case when you are only paying off one loan and not continuing with the snowball.
In this situation, all of the loan factors do matter. As a result, you must, unfortunately, analyze the exact effect prepayment will have on both loans to determine which one should be paid off (unfortunately for you, maybe – but I like spreadsheets and stuff like that!)
The scenario
The person told me that she has two loans, a car loan and a home equity loan (HEL). (Note: that much is true, but I am making up all values in the example below because I don’t actually know them). She and her husband have extra money in their monthly income that they want to put towards one of the loans and wanted to be smart about which one to pay off to get the most benefit from the prepayment. Here are the steps I would recommend in this situation:
1. Determine how you define the "greatest benefit"
The point of this exercise is to be smart about loan prepayment to realize the greatest benefit, rather than just flipping a coin to decide which loan to attack. Unfortunately, there isn’t a simple way to define what would provide the greatest benefit for each person. Typically, I would think that a person would define the greatest benefit in this situation as saving the most money in interest payments . That is the criterion I will use in this example. There are other factors to consider, however.
For instance, you may want to pay off one loan as quickly as possible to free up cash flow. It might not save you the most interest by choosing that loan, but you want to get rid of one ASAP – so the shortest time to pay off a loan would constitute the greatest benefit for you.
Another thing to consider, especially in a case like our example, is risk . If something comes up and you can’t make your car payments, the bank comes and takes away your car. If you can’t make your HEL payments, they come and take away your house! (well, they don’t "take it away" I guess, but they take you away from it!) Therefore, having a HEL (and a mortgage) presents a greater risk than having a car loan. Even if you don’t save as much interest by paying off your HEL, if it helps you to sleep at night knowing that you have one less loan on your house, then it may be worth the extra interest you’d pay. In this case, you would accelerate the HEL loan and think of it as paying a little extra for stress reduction. (like a massage, I guess)
2. Collect all the numbers for your loans
To calculate which loan to pay off, you will need the following information for each:
- Current balance
- Interest rate
- Monthly payment
- Is it tax deductible? (if it is, you also need your marginal tax rate)
- The extra principal amount you are going to put towards the loan each month
3. Find a loan payoff calculator
The easiest way to find a loan payoff calculator is a good old-fashioned internet search. Go to Google or the search engine of your choice and type in "loan payoff calculator" or something similar. You can also use a spreadsheet or financial calculator, but I find the loan payoff calculators found online to be the easiest to use, so that’s what I’m going to use in this example. Click here to use the calculator I used. (it will open in a new window)
4. Run the accelerated payoff scenario for each loan
In the calculator, fill in the values requested for one of your loans (balance, interest rate, payment, additional principal) and it will show you how long it will take to pay off your loan at the minimum payment and how long with the extra principal you specified. Write down the values it spits our or put them in a spreadsheet or something. At the minimum, you want to write down the Payoff Time Savings and the Total Interest Savings . Then repeat the process for the second loan. Here is a screen capture of the values for our imaginary HEL loan.
By the way, here are the values I used for the two loans:
| Loan | Balance | Payment | Interest Rate |
| Car | $15,000 | $346 | 5% |
| HEL | $12,000 | $280 | 7% |
The extra principal payments will be $200 per month.
I put in the values for both of the loans and got the following information – formatted in a nice spreadsheet (wait- ignore the last line in the spreadsheet for a minute):
5. Calculate the tax ramifications, if necessary
At first glance, we see that paying off the HEL saves $841 in interest (that’s money we keep and do not give to the bank!) while paying off the car loan would only save us $615. But hold on, there is one more thing to consider….TAXES! Well, not taxes paid, but taxes saved. Since the HEL is tax deductible for the person asking me this question, that must be taken into account to get a valid result. If there are no tax implications to either of your loans, skip this step.
Since the HEL is tax deductible in this case (they are not always, so check into it for your situation), by paying less interest over the course of the loan we will be getting a smaller tax deduction and a smaller tax savings compared to paying the full amount of interest. To properly compare the two loans "apples to apples," we must therefore take into account this reduced tax savings .
A simple way to do this comparison is to reduce the interest savings from the HEL loan by the percentage of your marginal tax rate. Calculating this might be a lot more complicated depending on your tax situation. If you are in the middle of your marginal tax bracket and will not be pushed into a different bracket as a result of having a smaller deduction, it is actually a fairly simple calculation.
To determine the total after-tax interest savings , take the interest savings for the HEL loan ($840.67) and multiply it by (1 – marginal tax rate). In this example, I will use a 28% tax rate, so 0.28 in this calculation. Thus, the actual interest savings after we consider the tax savings we will no longer receive is $605.28. [840.67 x (1-0.28)] Again, since the car loan is not tax deductible, we do not need to do this calculation for that loan.
6. Compare the interest savings
Now you can look at the last line of the spreadsheet (I trust you didn’t peek!). Comparing the $605 saved by prepaying the HEL with the $614 saved by prepaying the car loan is easy. When the taxes are taken into consideration, you see that accelerating the Auto will save you slightly more interest. Again, if there were no tax implications, we would have picked the HEL in this scenario.
Of course, the results are highly dependent on the specific loan parameters . If the car loan would have been larger or had a higher interest rate, we would have saved even more money by prepaying it. If it would have been smaller, maybe even at a higher interest rate, we might have saved less by prepaying it. Since all three factors come into play independently, it is important to analyze the numbers for your specific situation and not just follow blanket statements like "prepay the higher balance" or "prepay the higher interest rate" or "never prepay a tax deductible loan."
7. Get rid of the loan!
Now the fun part begins! You’ve seen the process I would use when determining which loan to pay off first. The most important step, however, is to actually start paying the extra principal and eliminate the loan (when it comes to debt, let’s talk tough and use words like "eliminate" or "eradicate" or "terminate"). Even if you choose the wrong loan, the most important step is still to do something and pay it off . And after you pay off the first loan, I would gently suggest that you consider paying off the next one (and the rest of them). The more debt that you get rid of, the freer you become (is "freer" a word…spell check didn’t flag it…hmm, it did flag "didn’t" though…and "hmm." Sorry, I’m back on task). Remember,
The rich rule over the poor, and the borrower is servant to the lender. Proverbs 22:7
Final thoughts…
I hope the explanation of this process is helpful (I’m hopeful that it will be useful to at least one person!). Again, this type of analysis isn’t really necessary if you are doing a debt snowball with the intention of paying off all your loans in succession. In that case, just decide whether you agree with Dave Ramsey and like to see momentum growing by making progress or whether you are strictly a "by the numbers" kind of a person who wants to pay the least amount of interest and can stay motivated if you don’t get to experience any short-term successes.
Another note:if you have a variable interest rate on your loan, it gets harder. As long as you can predict the future and know how the interest rates will change, you can still do a similar calculation. If you can’t do that (if you could, you would have already bought stock in the next Wal-Mart and used that money to pay off your loans…so I’m guessing you can’t), I would suggest you skip to Step 7 and just do something .
One final note: my assumption is that most people reading this post are already familiar with the debt snowball technique (or you don’t care about it). If this is a bad assumption (and you do care) please let me know and I will put together another post on Dave Ramsey’s technique and the similar interest rate based technique.
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5 Responses to “The Lesser of Two Evils: Determining Which Loan to Pay off First”
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I am in a similar situation, but it involves school loans and a car loan…school loans have the tax benefit. I am choosing to pay off the car loan even though the interest rate is higher on the student loan. The debt from the car loan is of no benefit to me. Plus, once it is paid off it will give me an additional $290 to put toward the school loan (now going to car loan). If all goes well in the perfect world…I would be paying $620/mo toward a $130/mo student loan once the car loan is paid off. That is nearly 5 times the current payment and the student loan would be paid off in about 1 year.
Tim,
It sounds like you have a good plan for getting rid of your loans. Good luck and stick to it. Just think, after you pay off that student loan, that $620 goes right into your pocket each month – that’s like getting a huge raise!
Thanks for the comment.
College is becoming increasingly difficult to afford. Thanks again for this post. Really nice post.
A loan is a type of debt. This article focuses exclusively on monetary loans, although, in practice, any material object might be lent. Like all debt instruments, a loan entails the redistribution of financial assets over time, between the lender and the borrower.
This is a great post. I used to have this same dilemma, but I learned a great strategy called the snowball effect. I don’t know if anyone has used this but how it works is you pay the minimums on all the debts you have except the smallest one. For the smallest debt you pay as much as you can ( hopefully 3-5 times the min) and once that is paid off you move onto the next smallest one and you add the minimum and the big chunk you were paying for the last debt and put that towards the next smallest debt. It works every time and I love it. You need to try it if you haven’t already.
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