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Which debts to pay off first

Chris Farrell Jan 12, 2010

Question: I am hoping you can help me with a question my husband and I have. We currently have an extra $1200.00 that we would like to pay towards either his student loan or our second mortgage and we are at odds over which one to apply it to in order to make it most useful. Here is the situation.

2nd mortgage.

5 years ago we purchased our home with a 80-15 loan. The 15% is on a 2nd mortgage and was for 30,000.00 it was on a 5 year arm at 9.0% interest. We recently refinanced that 2nd mortgage because the 5 years was up. the current interest rate is 7.5% on a new 5 year arm and the current balance is $26424.66. The required payment is about $245.00 per month and we pay $300.00.

Student loan.

My husband has a student loan left and the balance is $11549.66 with a interest rate at a fixed 6.0%. The required payment per month is $145.64 and we pay $200.00

Now my thought was that since the student loan has less of a balance we should take the $1200.00 and pay towards that even though the interest rate is less that way we could get one of the two bills paid off faster and then take the $200.00 we pay each month on the student loan and apply it to the 2nd mortgage. My husband however feels that since the interest rate on the 2nd mortgage is higher we should take the money and pay towards the thus saving money we would pay on interest. My thought is though they are both tax deductible and I would like to eliminate one bill completely. Could you please help us! Which of the two will get us the best results. Thanks, Susan, St. Cloud, MN

Answer: Fact is, you can’t lose whichever choice you make. You’re getting rid of debt. That’s the bottom line.

I agree with your husband that interest rates and interest savings matter. And you’re right to think that eliminating a debt is wonderful. You can run the numbers at a website like dinkytown.net.

Still, I always like to look at risk when mulling the trade-offs in a situation like this. However small, there is greater risk attached to a second mortgage than a student loan (assuming the student loans are federally-sponsored and not private ones). I would focus on getting rid of the second mortgage.

Here’s my reasoning: There is a great deal of flexibility built into student loans if you hit a rocky patch. You can defer student loans. You can go into forbearance. You can choose a different repayment option that reduces your monthly outlay. Yes, any of these choices will increase the overall cost of your husband’s college education. But it’s easy find financial relief in a pinch.

The same isn’t true with second mortgages, home equity loans, and home equity lines of credit. And in recent years second mortgages have been a real source of financial stress and money trouble. Your home is at risk if for some reason you fell behind on your second mortgage. Interest rates could be higher in 5 years, too.

These are fine distinctions, however. You’ll be better off financially no matter what at the end of the day. Congratulations.

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