Help With Debt – Which Loan do I Pay First – Evan answered

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Debt repayment advice for Evan

Evan asked:

What is your input on my debt repayment stuff I have posted here:  Goals and Objectives for 2010 – Help me Out!

Here is the gist of Evan’s sitch:

Current debts:

  • $12,000ish Auto Loan 8% – 7 year amortization schedule
  • $7,000 Law School Loan #1 – 5% 10 year amortization schedule
  • $57,800 Law School Loan #2 – 4.5%, but payments are increasingly tiered costs over 30 year amortization schedule
  • Mortgage of $228,000ish – 5.875% – 40 year amortization schedule

Nothing here screams at me get rid of it.  So the first question I have to decide is which one I am going to focus on? Here are my issues with each one:

  • It feels weird prepaying the Auto Loan since it is a depreciating asset.  It is very unlikely that I will own the car until it dies.
  • Law School Loan #1 is capped at 5%, and may be tax deductible
  • Law School Loan #2 is capped even lower at 4.5% and again may be tax deductible.
  • Mortgage doesn’t seem worthwhile since The Wife and I have plans to be out of here within the next couple years.

I think I am going to start paying down Law School Loan #1, but I want to hear alternating theories PLEASE TELL ME IF I AM WRONG. (I have since learned from Evan that he has changed his mind and is going to begin paying the auto loan off first.)

The next question comes down to How am I going to Pre-Pay the debt? I think I am going to prepare a whole bunch of $25 Checks marked “For Principal Only” and then send them weekly or bi-weekly depending how aggressive I am feeling that week.  Why $25? Because my checking account is unlikely to feel just $25.  Any and all income I receive from my blog will also be applied to that debt.

Debt reduction order and strategy

Luckily we’re not going into this blindly, as there are several popular debt repayment strategies we can draw upon for advice, then tailor our solution to Evan’s situation.  Today we will focus on the two best strategies:

  1. Debt Snowball – Dave Ramsey, the mouthpiece for this method although I’m not sure if he should actually be credited with its creation, advises thousands to order their debt repayment in order of debt account balances, regardless of account interest rates.
  2. Debt Avalanche – Flexo of Consumerism Commentary analyzed the math and came up with this strategy that is based on paying your highest interest (after tax) debt first, regardless of account balances.

Here is what I would do Evan:

I will answer both questions by suggesting a single strategic solution.

Although I am a big fan of both Dave and Flexo, in regard to a debt reduction strategy I have to side with Flexo on this one… not because I like him better (I dig both trailblazers), but because his math is better.

My advice to you is simple:

  1. Establish an emergency fund. You don’t mention the existence of an emergency fund, but do mention a trading account.  I advise you to close the trading account choosing instead to move the $2,000 into an high yield savings account for use as an emergency fund.
  2. Order your debts from highest interest rate (after tax) to lowest. Do this regardless of debt amounts.
  3. On the highest rate debt commit all available cash. Now that you have established an emergency fund in step one you can comfortably commit all extra cash to your highest rate debt.  That means the auto loan is the winner – as the answer to your first question.
  4. Make minimum payments on all debts except the highest rate debt. This will keep all other debt accounts current while you focus the bulk of your available funds to the debt that is costing you the most.  And committing all available funds to this debt is the answer to your second question.
  5. Wash, rinse, repeat. Follow this strategy all the way to debt freedom by simply replacing each paid off debt with the next highest rate debt until you are no longer in debt!

Many will argue in favor of Dave’s debt snowball plan, but as Flexo points out… they can never give accurate mathematical proof to support their claim.  Understand that I am not bashing Dave’s plan, if you or anyone else needs the emotional wins of paying off small debts first, then by all means they should employ the debt snowball.  But if you want to pay off debt as fast as possible while paying as little interest as possible, then follow Flexo’s debt avalanche method.

The Debt Avalanche will make your how much debt costs spreadsheet graph turn in your favor faster than anything else!

Above all things, always remember… “You can’t go wrong getting out of debt!”  – Dave Ramsey

What do you think?

Did I miss any glaringly obvious advice for Evan?  What would you do if you were in his situation?

If you need debt help or personal finance advice – Ask Matt Jabs.

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1 Jason @ One Money Design

Evan, You obviously have the motivation to make a change in your life and put this debt behind you. That is the first step. Get real serious about knocking out this debt. Sacrifice and go at it with intensity. You must hate the debt enough to make necessary sacrifices in paying it off. Making a recommendation is difficult without a full picture of your situation, but as Matt suggests, having an emergency fund is important. Make sure you have a monthly spending plan in place. Otherwise, you don’t know how much extra you can afford to pay on your debts. You must find a purpose for every dollar in your monthly plan. All of that being said, I like paying the lowest debt first here to build some momentum and get that sense of accomplishment Dave Ramsey and Crown Financial Ministries talk about. It will prove to yourself that you are serious about your plan. I like the auto debt pay off as the next one. Next, the remaining school loan and your longer term plan can include living without a house payment. Good luck and God bless you.

2 Matt Jabs

I agree with Jason’s admonition to live by a budget… that is foundational and utterly important. When it comes to the debt repayment though… I do not think the debt snowball is the best plan for Evan. Evan seems to have a solid desire for debt reduction already established, and because of that he should follow the best mathematical solution, which is the debt avalanche. The debt snowball is more for people who need little wins to maintain motivation. I think Evan already has solid motivation and resolve.

Is this true Evan?

3 Financial Samurai

Evan – I’d pay down that ugly auto loan. Yes, you’re losing money on your car, but you’re losing MORE if you don’t pay down that loan sooner.

Are you allowed to deduct the student loan interest on your income taxes? I have a feeling no, since you are a lawyer and make above the threshold.

Pay off the auto loan first, and swear NEVER to take a money sucking auto loan again!

4 Matt Jabs

I agree, auto loan first.

In his goals post Evan says that both student loans may be deductible. Sam is right… it is important to figure this calculation of after tax importance when ordering your debt avalanche.

5 Evan

HYSTERICAL SAM,

“Are you allowed to deduct the student loan interest on your income taxes? I have a feeling no, since you are a lawyer and make above the threshold.”

NOT ONE PERSON IN THE BURSAR’S OFFICE TOLD ME ABOUT THE THREASHOLD WHEN I WAS SIGNING MY LIFE AWAY! lol
When I got married I fell under the threashold because the Wife doesn’t make as much.

http://www.myjourneytomillions.com/articles/education-loan-interest-not-always-tax-deductible/

6 Matt SF

Based on your data, I’d hit the Auto Loan at 8% very hard.

For prepaying, I would create a monthly budget and identify how much extra income you have left over every month. If you have an emergency fund in place, I would commit as much as you feel comfortable paying down your account balance. I see no problem committing 75% to 100% of your “disposable income” if your job and cash reserves are solid.

7 Matt Jabs

Spot on Matt.

Evan – this is the second piece of budgeting advice, which I wholeheartedly agree with. You elude to a “zero-based budget”, so you must have an average amount of disposable income to put toward your debt each month correct?

8 Anthony

I would pay them in the order that you listed.

1. Auto Loan
2. Law School Loan #1
3. Law School Loan #2
4. Mortgage

For me, the decision is easy. Your auto loan and first school loan are the smallest debts in amount. Also, the auto loan has the highest rate, and loan #1 is third by <1%. Having said that, you would be paying your debt via a Dave-ish/Flexo-ish mixed method.

After those two, pay off the second school loan, then mortgage. This follows my "just because" philosophy. Pay off your mortgage "just because" it's a mortgage. Pay off everything else first.

I think that after tax deductions, you'll likely find that my order is the same as Evan's.

9 Matt Jabs

The Dave-ish/Flexo-ish mixed method is another solid option in that it would most likely order all non-mortgage debt should be paid first – I especially like this solution in regard to unsecured debt like student loans.

Take your pick Evan. Mathematically Flexo’s plan will probably order the mortgage paid off before the student loans (due to amounts) but if you want to get rid of student loan debt first, then follow the mixed method. You will pay slightly more interest over the life of the loans but you will get rid of the unsecured debt first.

Either plan is solid.

10 Raymond Ott

Hi there Evan,

Just to offer another point of view for the discussion here…

Why pay off the debt early at all?

If we define that your debt, income, and assets are all a part of your personal economy then we can build a more perfect view of your situation.

When you pay off debt, that money is gone out of your personal economy. If you need that money later then you have to qualify for another loan, another loan = more debt. And what if you don’t qualify?

Instead of paying off debt with liquid assets (cash), why not leverage that money to make you money. There are plenty of investments out there that you can take advantage of even in a tough economy. Compound interest earned on your liquid assets (cash) can far outweigh the interest that you are going to pay on your current debt.

Let me give you an example…

If you pay all the normal payments on your current debt and instead of paying an extra say $300 toward your car payment until it is paid off, make that same $300 payment to yourself in either a savings account or some other savings vehicle. By the time your car is paid off ($12000) you will also have a savings vehicle with $12000 cash + any compound interest you have earned on that money. So if you have say 3 years left on your car loan, then at the end of that 3 years you have also build up a savings equal to 3 years worth of car payments.

Just a thought.

11 Matt Jabs

Something that cannot be accurately calculated is the fact that keeping debt presumes upon future earnings. If job loss strikes the less debt the better.

Also, in the above auto loan example you’re forgetting about the interest he’ll throw away in interest on the debt, which is way higher than anything he’ll earn in a savings account… especially now-a-days.

Investing rather than paying off debt can make sense in some situations… but this is not one of them – IMHO.

12 Raymond Ott

I understand your reasoning, but if job loss occurred at 18 months there would be $6000 in savings to continue to pay all 4 debts for 60-90 days until he got a job again. If you take all the cash out of your personal economy he could potentially lose his car and his house in 60-90 days if he didn’t get a job right away.

And you dont have to touch the emergency fund.

just another way to skin a cat.

13 Robert Espe

The fastest way out from under that auto loan is to sell the vehicle and get a cheaper one. I like Financial Samurai’s 1/10th rule for autos.

I would also say get rid of the mortgage completely until the student loans are gone, especially such large ones. Renting is cheap, and provides flexibility if you are moving often enough to feel that prepaying a mortgage isn’t worth it. I like being debt free and socking away $20k+/yr towards my future home.

14 Matt Jabs

My wife and I are upside down on our home – we bought it with zero down nearly three years ago – so we are VERY excited to have reducing the 2nd mortgage by $20,000 as a financial goal for 2010. Once we get our mortgage loan amounts equal to the home value again, we plan on selling, renting, and saving for our dream home on acreage.

15 Evan

Wow great stuff everyone! I am not a frugalist, and currently am alright with going forward with my normal lifestyle. I have been blogging for about 18 months and in that time got rid of 18k in credit card debt, I have more than enough in cash to pay off the auto note tomorrow. But I am not willing to give my 4+ month emergency fund.

No one really discussed the idea of throwing money at a depreciating asset. Notwithstanding after some wondering I have decided to keep the car and pay off the note as soon as possible. I came up with this because of the discussions here and I finally asked myself, “what the hell am I doing?”

I have a car with 52K miles that will last another 50K without a real problem, and at $289/month I’ll never have a cheaper/month car.

16 Dan

Evan, no one really discussed the idea of throwing money at a depreciating asset, because that’s not what you’re doing.

Assuming you have a secured loan, you have a contractual obligation to repay the car loan, or it will get repod. Your car would get repod and sold at auction. You could then be sued for the difference of your loan and what the bank got for your vehicle at auction.

If it is unsecured, then your defaulted loan would get sold to a junk debt buyer, who would likely sue you in court for the unpaid balance of the loan. And since you do have a contractual obligation to pay that balance, the question you must answer is what’s the cheapest way to repay that balance. The less money you pay toward it, the more it costs you.

If you simply sold the car, you’d still be responsible for the note. That is, assume your car is worth $5k, and you can get that much for it in a private party sale. You’d be able to pay down your note, but you’d still owe $2k.

Your concern about a depreciating asset comes in to play when the vehicle needs repairs. Right now, your only concern is about the cheapest way to manage your debt.

17 Evan

Dan,

It is moot, since I have already said I would go with the auto note. But your assesment of my concern of a depreciating asset is completely incorrect. Wikipedia defines a depreciating asset as,

“…depreciation is the reduction in the value of an asset due to usage, PASSAGE OF TIME, wear and tear, TECHNOLOGICAL OUTDATING or obsolescence, depletion, inadequacy, rot, rust, decay or other such factors.” emphasis added.

As such, simply the passage of time decreases the value of the automobile, not just repairs as you put it. I am fully familiar with contract law and recourse / non-recourse loans which is what you were hinting at, but that has little to nothing to do with the discussion.

My true concern, which I feel better about because I made the decision to keep the car, beyond the note, was that EVERY dollar I put into the debt repayment, if I sold the car before the note was naturally paid in full (i.e. never utilized the car beyond the ending of the note) would be worth less than said dollar the very next day because the asset was losing value by just sitting in my driveway.

For example (not my example, and it is extreme on purpose): I pay down $1 of a $10K note and the car is worth $10K. The very next day (extreme example) the note is $9,999.00, but my car DEPRECIATED and can only be sold for $9,000. Putting my extra dollar which could have utilized for something else – was not used to its potential.

Again, it doesn’t really matter if you understand/agree since I already have made the decision to keep the car beyond the time I originally thought.

18 Dan

I only brought it up (depreciating assets) because it appears you thought it was a bigger point than the rest of us did — I mean, you called it out as if it was something that should have been discussed but wasn’t. As this could be a useful discussion for subsequent readers who might wonder the same thing, it’s worth a quick discussion.

I disagree with your using wikipedia’s definition to classify an auto as a depreciating asset — you could use the same logic to classify a house as a depreciating asset, yet it is generally accepted that houses at a minimum hold their value over time. However, I do agree with you wholeheartedly that an auto is without a doubt a depreciating asset.

Evan wrote:
For example (not my example, and it is extreme on purpose): I pay down $1 of a $10K note and the car is worth $10K. The very next day (extreme example) the note is $9,999.00, but my car DEPRECIATED and can only be sold for $9,000. Putting my extra dollar which could have utilized for something else – was not used to its potential.

I’m cool with extreme examples on purpose — especially with numbers — it makes things very clear. What I was trying to get at in my previous post is that you really have two mutually independent factors here. The first is your car (which is an asset to you) and that car has some value. You likely use a third party pricing guide (like Kelley Blue Book) to determine its value. The key point here is that the current value of your car is independent of what you owe RIGHT NOW to your bank on the note.

The second is the car note (a liability) and the value of this liability was the terms under which you and the lender agreed — in this case, $12,000ish loan, 8% APR, 7 year term. (I’ll go with 12 thousand even here). According to bankrate’s auto loan calculator, a $12,000 loan with the above terms results in a monthly payment of $187.03. Over the course of the loan, you will have paid $15,710.52, or $3,710.52 on top of the $12k principal. Adding $25 each month to this payment would pay this loan off in 6 years instead of 7, and your total interest payments would be $3,115.96, or $594.56 less than what you paid before. (So by making an extra $1775 — that is, $25/mo for 71 months — you’d save yourself 13 months of $187.03 payments, or $2431.39)

So why then, do you think your dollar (or $25) could have been better utilized for something else, as it wouldn’t be used to its potential?

As for the fact it doesn’t really matter if I understand/agree because you have already made up your mind, all I can say is that until you have a better handle on some basic PF concepts, your journey to millions is going to be hampered by poor financial choices. One such choice might be the decision to finance a $12,000 car over 7 years. If you couldn’t afford a shorter amortization period, you could have bought a cheaper car. For example, you could have bought a $7,000 car, financed it over 4 years, and only paid $1202.74 in interest while having a slightly cheaper monthly payment. But instead, you chose to pay $3710.52 in FINANCE CHARGES on a DEPRECIATING asset. Was a more expensive car really worth an extra $2500 in interest payments?

19 Evan

“I disagree with your using wikipedia’s definition to classify an auto as a depreciating asset — you could use the same logic to classify a house as a depreciating asset, yet it is generally accepted that houses at a minimum hold their value over time”
- The last fifteen words mean exactly the opposite of a depreciating asset

I have absolutely no doubt in my current understanding of both basic and advanced PF and tax concepts (some investing….get a little confused on advanced option plays lol).

“So why then, do you think your dollar (or $25) could have been better utilized for something else, as it wouldn’t be used to its potential?”
- Regardless of whether you agree, I thought I explained at least where I was coming from?

Why wouldn’t I take the longest amortization table if I could prepay without a penalty? If I pay it off in 4 (this will be the fourth year and it is likely that I will pay it off this year or early next year – not at $25/month, but likely from side income from blogging and my side practice.

20 BG

Evan) That is a great plan, take the longest schedule possible, with the intent of making extra principle payments each month. That is a smart thing to do, especially if the interest rates between short and long periods are not that different.

The benefits of the plan are that you will always be making higher-payments than required, but if you run into a bind with an unexpected loss of income (or increase in bills), then you can immediately switch to just making the smaller minimum required payment.

But this tactic requires real dedication and motivation on your part to stick too, and the majority of people will not follow through on the original plan.

Seeing a 7-year car note, and a 40-year mortgage really looks bad from my point of view. But as long as you entered these deals with the plan (and are following them) of actually paying the car off in 4-years and the house in 15-years (or less) then that is fine.

If you financed the car for 7, and the home for 40, because that would be the only way to afford the monthly payments, then those would be huge mistakes, and you should sell those assets and purchase alternatives more in your pay range.

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