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Reader Question: Which Loan Should I Pay First?

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I got a question from a reader recently and when I tried to e-mail her back the email bounced back to me. Seems pretty odd because it was persons full name at a very well-known company. It was a well thought-out question and I hate to leave it unanswered, so I figured I'd make a post of it. I hope she's ready. I'll give her my typical code name of Buffy Summers and change around the loan numbers a bit to protect her identity.

I have a loan situation that I need some advice on. I have been struggling with the best way to pay off 4 loans with the same interest rate. I want to pay these off in whatever order will have the least interest paid overall. I can't seem to find any information through researching on the web as to the best solution for this (and I'm not much of a finance person either!) The monthly payment for these 4 loans is lumped together at $373 per month. I'd like to pay an additional $300 per month, but don't know if I should apply this extra money "strategically" across the four loans or only to one. Does it make sense to pay the highest loan first so that I can tackle the interest portion of each payment earlier rather then later? I have been using this loan comparison calculator and after playing around with different numbers, it seems like it makes most sense to pay across all four:

Here are the loan amounts:

Current Interest rate on ALL four: 6.75%
Number of payments left: 197

Loan A: $6,000
Loan B: $8,000
Loan C: $11,000
Loan D: $19,000

Here are the different payment scenarios when applying an extra $300 (as I am understanding it):

Scenario #1: Apply extra $300 to lowest loan first
If I did this, I could pay off Loan A in 1 year, 7 months, with total interest paid of $327. I can apply the extra minimum payment towards the other loans, plus roll over the extra $300.

Scenario #2: Apply extra $300 to highest loan first
If I did this, I could pay off Loan D in 4 years, paying a total of $2,323.79 in interest (just for that loan, this doesn't include the interest on the other 3). Again, this would leave me the extra minimum payment I had been paying towards Loan D, plus I can roll-over the extra $300 at that point to the remaining 3 loans. How can I figure out the total interest paid over the life of all 4 loans this way though? I need a calculator like the one I am using that ALSO lists the amortization schedule?

Scenario #3: Apply extra $300 equally across all 4 loans
4 extra payments of $75 are applied to each loan. This would be $11,947 in interest paid over the life of the loans. However, the smaller loans would obviously be paid off sooner, meaning I could just roll over that money to the other loans (and I am assuming this would lower the amount of interest even further). Is there an easy way to calculate this?

Scenario #4 (what I have been doing for the past 2 months)
Apply extra $300 across all four loans based on percent of each individual loan amount I make the following extra payments towards each loan:

Loan A: $40
Loan B: $55
Loan C: $75
Loan D: $130

When doing it this way, I pay $11,474 extra in interest over the life of these loans.

Am I doing these calculations correctly? How should I best apply this extra $300 each month so that I pay the LEAST amount in interest over the life of all these loans? I read alot about how its better to pay the lowest loan first because it's "psychologically" better. However, I don't care about the psychological aspect of paying these loans off, I care about paying the least amount of interest over time.

Here are my thoughts:

It mathematically shouldn't matter if all loans are the same interest rate. Buffy should end up paying the same interest. I put the emphasis on shouldn't because my math isn't what it used to be. Also, I was too lazy to find a loan amortization calculator to hand her, but there should be some good ones at Dinky Town.

However, I can see some factors that Buffy should consider:

She mentioned the "current" interest rate on all loans is 6.75%. Are they locked into that rate for the length of the loans? If not, perhaps she can anticipate which might increase in the future and pay those off first?

I'm with her on the psychological aspect of paying off loans. In the end, she knows she's got $X in debt to pay, so getting rid of it the fastest is best. Sorry Dave Ramsey!

Readers, can you let me know what else I missed? Also, please feel free to contact me with questions any time using the contact button at the top of the page.

Last updated on May 9, 2012.

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15 Responses to “Reader Question: Which Loan Should I Pay First?”

  1. bubba says:

    Why do you have so many loans anyways? I’d cut spending/saving and pay them all off. No use in paying interest when you don’t have to. Use some of that alternative income!

  2. Tom says:

    I would send the extra money to the smallest loan first.

    Mathematically, it doesnt make any difference where the money goes, but if the smallest loan is paid off first, it frees up the additional principal payment to be applied to the next smallest loan, and so on. It is basically Ramsey’s snowball. The trick, of course, is to NEVER lower the total payment being sent in. Once one loan is paid off, add that principal amount to the next loan and continue until they are all gone.

    The goal here is to make sure that you reduce your principal as quickly as possible (less principal equals less interest).

  3. Lazy Man says:

    Bubba, I don’t have the loan… this was a question from a reader. I don’t know if she has any alternative income or the reason why she has the loans.

  4. Yeah, if the rates are all the same, the total interest paid shoud be the same. Unless maybe one loan is paid on the 1st and another is paid on the 31st? What I mean is that if you start making the extra payments in July, you’d be paying the extra $300 on July 1st if you were putting it toward the loan that was due on the first, and be paying the extra on July 31st if you put it toward the loan that was due on the 31st? Obviously, the sooner the money exits your account and is paid toward the loan, the better.

    Very good point about the “current” aspect of the rates. If one of the debts has a more volatile rate than the other (example credit card vs. car payment), you’d want to pay toward the more volatile one first, in case the rate jumped suddenly.

    Using a mortgage to pay off the loans makes the interest tax deductible, which is nice …

  5. Sonny says:

    Assuming the interest rate is the same, I would pay the lowest amount first, just to get it off the books.

  6. John says:

    I have a similar situation with my student loans. I chose to pay extra on the smallest balance. Since i started making extra payments ahead on that loan the interest rate for that loan dropped. At this point i moved the extra to the lowest balance at the higher rate. Once again the rate dropped now i have 2 loans with lower interest rates than the rest.

    The interest paid between all loans will be the same no matter the payment method. The 3 major factors to consider are; will the interest rates change (increase or decrease) ; am i making a big purchase (car or house) soon; and do i want fewer outstanding loans. If rates will change pay such to maximize the change. If rates are locked in then pay off the small debts first to reduce the number of outstanding loans. If you are planning to make a big purchase, that will be a new loan, pay down the higher balance loans first to increase your debt availability ratio.

  7. Jim says:

    I’d bet they are student loans. 4 loans all at the same rate would be a result of 4 years of college. If they were credit cards or other kinds of loans then they would most likely have different % rates.

    If they are variable rate student loans then she might look into consolidating at a fixed rate. That would let her lock in a relatively low interest rate and get a single payment.

  8. Matt says:

    I didn’t believe it until I crunched the numbers for myself. I used this loan amortization schedule for excel: http://www.vertex42.com/ExcelTemplates/loan-amortization-schedule.html

    I made 4 copies of the worksheet (one for each loan), and then compared the numbers paying lowest-highest and highest-lowest, either way gets you finished in roughly the same number of payments and with the same interest paid out.

  9. Roger says:

    As others have mentioned, if all the loans are the same type and the rate is fixed and equal, it shouldn’t make a difference what loan she pays off first; the interest paid over the lifetime of the loans will be the same. So, she should do whatever makes feel most comfortable; whether that is pay off the lowest loan first to cut down the number of loans or pay down everything equally.

    If they aren’t the same type of loan, then things become more complicated. If some of the loans have tax-deductible interest (student loans, mortgages), those should probably take lower priority than loans that don’t have any tax benefits. And, as mentioned in the original post, any loans that can increase in the future should be paid off as soon as possible.

    Interesting question, and hopefully she got her answer, even if it was impossible to reach her directly.

  10. Randy says:

    I agree with what you said, it shouldn’t make any difference, consider which one MIGHT increase the rate, etc.

    Two confusing points: 1) You apologize to Dave Ramsey, but your idea is the same: pay off the smallest first. Why apologize. 2)You said “a HELOC can be dangerous in a poor housing market and an economic downturn as we’ve seen.”

    Why is a HELOC dangerous in a down market? Suppose you own a house worth $200k and you take out a HELOC for that amount (assume that the house is paid-for). The house value goes down to $150k. You now owe more than it’s worth. But regardless, you still owe $200k. What has changed?

    I’m with her on the psychological aspect of paying off loans. In the end, she knows she’s got $X in debt to pay, so getting rid of it the fastest is best. Sorry Dave Ramsey

  11. cannon_fodder says:

    Let me take a different tact. She wants to get rid of these loans. If she were to apply additional payments to the smallest loan that would leave her with only 3 loans.

    How about she goes after the biggest loan first? The reason being that it will take longer for her to get rid of it which might also make it less likely for her to take on additional debt.

    From a cost perspective it is identical but from a practical point of view (and she says she is not into the psychology a la Dave Ramsey) it might be better for her simply because it continues to demonstrate the difficulty of getting rid of debt. And that can be a greater teacher to discourage additional debt.

  12. Lazy Man says:

    Randy,
    I don’t agree with Dave Ramsey in paying off the smallest. Dave Ramsey is big on the psychology on having a fewer number of loans to pay and Buffy (the reader) and I both agree that we don’t care about the psychology – we just want to pay the least interest. This is just a case where it doesn’t matter because the interest is the same.

    The problem with HELOCs comes if you don’t make your assumption (“assume that the house is paid-for”). I’ve also seen banks change credit limits at the same time that rates go up, which leads to potentially living on some thin ice for some in my mind.

  13. Scott says:

    Some to consider. Some have been addressed.
    1) If any of the loans will reset at a higher rate they should be targeted first.
    2) Any loans that are tax deductible should be paid last as their effective rate is lower.
    3) Student loan interest is deductible on the front of the 1040 so you don’t have to itemize. But also remember that if things fall apart completely they cannot be written off in bankruptcy either
    4) A HELOC is only sometimes tax deductible and only if you itemize. If you don’t itemize your taxes then you get no benefit from it

    The psychology is important regardless. If the persons personality leans toward taking on more debt they should focus on the largest so they will keep seeing 4 loan payments and keep them from taking on more. If they would rather get the charge from paying off a debt pay the smallest loan off first.

  14. Kelly says:

    Hi everyone! This is my post! Thanks so much for posting a response and thanks for all the comments. I am intrigued by the thought of paying according to the day of the month the loan is due. My student loans all accrue interest on a daily basis. Given that, how does that change things? Wouldn’t it make more sense to pay the highest loan first since there will be a higher rate of dollars being applied to interest overall? Since the highest loan accrues the most interest per month, by tackling this one first, I will reduce the amount and have more for principal. Am I thinking this through correctly?

  15. Kelly says:

    Oh, by the way, here is more information. The total amount of principal outstanding, and the monthly minimum payment due.

    $6,006.34 $50.71
    $8,162.38 $69.20
    $10,924.89 $92.26
    $19,156.14 $161.75

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