Question: I have been paying down my debt using the snowball method. I’m making great headway and have cut my debt load in half in 3 years. I’m at a point where I need to choose between a home-equity loan with a variable rate (currently at 4.24 percent but eligible for tax deductions) and a car loan at 3.5 percent fixed. Which makes more sense to pay down? Scott, Chatham, MI
Answer: Congratulations on your success at paying down debts. Your question gives me an opportunity to review the two main debt-reducing strategies.
One method comes with names like debt roll-up, debt avalanche, and master repayment strategy. It’s the math-savvy way to attack the problem. Here’s the logic: Make a list of debts, putting the one with the highest interest rate first and the lowest rate last. Target extra savings at the debt with the highest rate first and pay the minimum on everything else. When the steepest-rate debt is gone, go after the next highest, pay the minimum on the rest and so on. Credit guru Gerri Detweiler is a leading proponent.
The other tactic is the approach you’ve taken: the debt snowball. Once again, you make a list. But this time you start paying off the smallest debt first and end with the biggest debt. Forget the interest rate. Attack the smallest debt first and pay the minimum on the rest. This method is about harnessing emotions to stay the course. It’s about getting some momentum from successfully eliminating the smallest debt first. Its leading proponent is well-known personal finance advisor Dave Ramsey.
What matters is finding the method that works for your temperament and lifestyle. Either way, you come out ahead.
OK, now to your question. My instinct is to go after the home-equity loan first and the car loan second. The car loan is at a fixed rate. Your cost is locked in (although you can pay more than the required monthly tab without penalty). Interest rates could rise above 3.5 percent and it wouldn’t matter. You’ll pay the same rate month after month. In sharp contrast, your home-equity loan is a variable-rate debt. The risk embedded in the loan is, if interest rates go up, your monthly tab will rise, too. If inflation picks up, the rate on the home-equity loan could go up. The risk trade-off between variable and fixed is why I usually favor attacking the floating-rate debt over the fixed-rate debt. I still lean that way.
A counter-argument runs along these lines. It’s highly unlikely that we’ll see much of an increase in rates for a long time. The economy is too weak and the demand for credit too little to send rates up much, if at all. Inflation is tame for now. The risk is pretty minimal. The car loan is on a depreciating asset, so you’d want to retire it as quickly as possible, while your home-equity loan is on an asset that at least has the potential of appreciating with time. (Yes, someday the housing market will improve.) The tax deduction on home equity gives you a bit of an extra cushion.
Still, if I’m weighing these trade-offs, I would target the home-equity loan.