A debt elimination strategy

Question: Our family of six is currently living in a home that is worth significantly less than the $227,000 we owe on the first mortgage and $35,000 that we owe on the second mortgage. The first mortgage (a refi from five years ago) is interest-only for the next 5 years, and then the remaining principal will be amortized over 20 years. We don't qualify for any type of mortgage modification through the bank or the government. The good news is that our income situation has recently improved and we have about $1000 each month after paying living expenses and credit minimums to apply to debt, savings and retirement. We are just not sure how to allocate this money. I was wondering if we might try to pay off a portion of the principal on the first mortgage ($350 per month for the next five years) and split the difference between reducing credit card debt (currently $27,000) and saving for emergencies/retirement. Any suggestions? Bonnie, Linden, VA

Answer: I love it when I hear that someone's finances have taken a turn for the better. It doesn't happen often in the current economy.

My reaction is that you have two short-term vulnerabilities with your debt: The credit cards and the second mortgage. I agree that you should build up your savings. But with the remaining extra money I would aggressively target the credit card debt. Focus on it.

It's your high interest rate debt. I would pay the minimum on your other debts and put the extra savings toward the credit card bill.

When you have eliminated the credit card debt I would go after the second mortgage. The risk of a home equity loan is that the loan will become increasingly expensive when interest rates start to climb (and that will happen someday). Let's get rid of that vulnerability.

You can play with the percentages, but what about one-third into savings and two-thirds into the credit card bill?

By the way, once you've built up savings and eliminated the credit card and the second mortgage you'll want to look at your mortgage and see if you can do better. Hopefully by then it will have gained back most (all?) of its value.

About the author

Chris Farrell is the economics editor of Marketplace Money.

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