Pay down debts

Question: I have three big debts with 3 different interest rates. The first one is my car with zero percent interest for 4 more years, on which I pay $800/month. Second one is my second mortgage, which has an adjustable rate now at 3.75%, on which I pay $300/month, and owe 65K. Third one is my mortgage with 7.5% interest, on which I pay 1500/month not including escrow of 500/month. I owe $210,000 on that. I will have an extra $1200/month extra to pay down these three debts.

My question is: Which should I pay down first?

Should I pay extra on all 3 per month?

If I pay off the car first, I will have $2000/month to place on the next two; if I then pay off the second mortgage, I will have $2300/month to pay off the first mortgage.
But what about the rule of paying off the highest interest rate first? It would take me longer to pay off my first mortgage, with the highest interest, if I only place $1200/month extra on it. Help!! Camilla, Northville, MI

Answer: I'm glad you're working down your debts. But I wouldn't go after all three at once. I would focus on paying off the second mortgage first and the auto loan second or the auto loan first and the second mortgage next..

For now, I wouldn't accelerate payments on your first mortgage. Instead, I would see if you can refinance it since the current 30-year fixed-rate mortgage rates is at 4.8%. I'd contact your banker--and shop around, too--and see if you qualify for a refinancing. You'll run the numbers, of course, but a gap of 2.7 percentage points between your existing mortgage and current rates you would free up cash flow--almost $350 a month or more than $4,000 a year. (I quickly ran the numbers at dinkytown.net and assumed you had 25 years left.)

When making a list of all consumer debts the two "good ones" are student loans and mortgages. (In both cases its money you've borrowed to invest in your future.) You want to get rid of all other debts first.

I would focus on eliminating your car loan and second mortgage. Yes, you have a no-interest loan on the car, but you're paying for an asset that is depreciating in value. It's still a loan obligation. The second mortgage has a key risk built into it: Higher interest rates. To be sure, the expected rise in U.S. rates hasn't materialized so far in 2010. The economy is too weak and rates are staying down. Still, it's a prudent bet that at some point the Federal Reserve will start hiking short-term rates and a stronger economy will put upward pressure on long-term rates. And then the rate on your second mortgage will go up.

Which do you pay off first? There are two main methods. The mathematics of paying off the higher rate loan first is compelling. It's the starting point in most debt-reduction strategies. You would put the extra money each month toward the home equity loan and pay the minimum on the car loan.

Nevertheless, there is a genuine psychological boost from attacking the smallest debt balance first and eliminating it. I favor the mathematical approach as a general strategy. But the early-success method has a lot going for it, too. It's fine if you decide to concentrate on getting rid of the auto loan as fast as possible and then turn your attention to paying off the second mortgage.

The bottom line: Use the method that works best for you.

A good book for setting up a DIY debt program is Reduce Debt, Reduce Stress by Gerri Detweiler, Nancy Castelman and Marc Eisenson (Good Advice Press) 2009. The authors offer very practical information on all aspects of escaping debt. You can find the book at their website.

About the author

Chris Farrell is the economics editor of Marketplace Money.

Comments

I agree to American Public Media's Terms and Conditions.
With Generous Support From...