What loan should I pay off first?
Determining which large expense you want to pay off first can be challenging. Between student loans, a mortgage, an auto loan, and more, it can be impossible to determine which one you should pay off first. Win this article, we’ll ask a set of questions that can help you narrow down your results to help you make the best financial decision.
Different Ways to Pay Off Loans
People have different ways of deciding which loans to pay off first. Some will say that paying off your loan with the smallest balance first is the way to go to create a snowball effect for your personal finances.
Others will say to pay off your loan that has the largest interest rate first in order to pay the least amount of interest. This way of paying off loans will keep some of your loans open longer but will allow you to pay more towards them because of lower interest costs.
We tend to lean towards the second type of methodology. While it might feel like you aren’t making as much progress, you can still watch your balances go down quicker while leaving more money in your pocket.
Create a List of your Loans
When determining which loan you should pay off first, you’ll need to know the summaries of your loans including the balances, interest rates, minimum payments, and how they are amortized. This will help you to determine which ones should be paid off first and which ones can wait a little longer.
Determine Which Loan has the Highest Interest Rate
Look at the terms of your loans to determine which loan has the highest interest rate. This loan should become a priority to pay off because of the amount of interest you will end up paying over the life of the loan.
Analyze Amortization Schedules
An amortization schedule is defined as “a complete table of periodic loan payments, showing the amount of principal and the amount of interest that comprise each payment until the loan is paid off at the end of its term”.
Whenever you pay on a loan, some of your money will go towards the principal balance some will go towards interest, and some might even go into an escrow account for things such as property taxes and insurance. It’s important to understand which loans offer the most favorable amortization schedules so that you can put them on the back burner.
Loans such as mortgages do not tend to have favorable amortization schedules. In the first few months and years of your mortgage, 80-90% of your payment will go toward interest alone. In a conventional 30 year fixed-rate mortgage, you will oftentimes end up paying as much in interest as the home initially cost.
For example, a mortgage with a 3.75% interest rate that costs $200,000 will cost you a total of $333,433, $133,433 of that being interest. Want to know how much your mortgage will cost? Be sure to use our Mortgage Calculator here!
Student Loans vs Mortgage
Student loans typically have higher interest rates when comparing them to mortgages however, the term of the loan is typically shorter. Depending on how much you owe, it’s probably wise to knock out your student loans before paying extra on your mortgage. Be sure to make additional payments on the principal balance.
Auto Loan vs Mortgage
Your auto loan and mortgage probably have pretty similar interest rates but they amortize differently. Because of this, putting your additional cash towards your mortgage is probably a good idea. Depending on how long you have left on your mortgage, you could match the amount you pay down in interest alone.
For example, if you paid an extra $2,000 on your mortgage, you could save $2,000 on interest over the life of the mortgage, plus reduce your overall mortgage balance. If you were to put that $2,000 to pay extra on your auto loan, you might save a hundred bucks or so on the interest.
Personal Loan vs Credit Card Debt
To determine which one is better to pay off first, you’ll need to determine the interest rate on both. Typically, a credit card will have a higher interest rate making it the better choice.
Student Loan vs Auto Loan
Student loans and auto loans are typically structured pretty similar. The interest rate on your student loan is probably a little higher, however, making it the right option to pay off first.
How to Lower Interest Rates
Whenever you look at your loans, you’ll probably cringe at the amount of money you’ll end up paying in interest, especially larger loans like a mortgage. There are a few ways that you can lower your interest rates, however.
One way to get a lower interest rate is to refinance your loans. If your credit score is better than it was when you originally got the loan and market rates are similar, you should qualify for a lower interest rate.
You can check today’s interest rates on refinancing here!
You’ll be surprised to know that sometimes the only thing stopping you from lowering your interest rate is a phone call. By talking to a customer service rep you have the potential to get a lower interest rate. State your reason for a lower rate and get their feedback. Some good reasons for a lower interest rate are:
- Lower rate found elsewhere (threatening to leave)
- Responsible customer (always pay on time and in full)
Determining which loan you should pay off first can be difficult but by following the steps above, you can make the best decision given your financial circumstances. Mortgages, student loans, personal loans, and auto loans can cost you thousands of dollars per year in interest alone, so paying them off early is a no brainer. It’s always a good idea to lower your interest rates if possible by either refinancing your loans or working with your current provider to see if they are willing to lower your rate. Regardless of the outcome, by paying off your loans early you can save thousands of dollars
Be sure to subscribe to our blog to get the latest in personal finance, investing, and more delivered directly to your inbox below!