prepay car vs mortgage

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prepay car vs mortgage

Postby jmuc85 » Tue Jan 29, 2013 1:23 pm

Hello,

I'm trying to decide whether to allocate a portion of my monthly savings towards my car loan or mortgage.

Details:

Emergency Funds: 4 months (recently reduced to make 2013 roth contribution + car down payment, building this up to 6 months before prepaying anything)

Mortgage: $182,000 at 3%, value of $240,000, monthly payment of $1,086. I'm about 6 months in on a 30yr mtg.
Car Loan: $15,600 at 1.99%, 56 months remaining, monthly payment of $287.

Tax Filing: Single

25% Federal Tax / Approx. 5.8% MO

Age: 27

Quick and dirty portfolio:
401k: $20,000, contributing 10% (including fully vested match)
RIRA: $20,000, 2013 contribution already made

I'm currently saving about $1,000/month in cash (outside of 401k). So I basically want to know thoughts on whether to use one hundred or two of that cash to put towards the car loan or the mortgage. Even though the car is at a lower rate, even after considering the tax deduction of the mtg interest, my gut says to pay the car loan to get it out of the way, and then once it is paid off, put the amount I was paying on the car towards my monthly mtg payment. Thoughts?

Thanks
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Re: prepay car vs mortgage

Postby Grt2bOutdoors » Tue Jan 29, 2013 1:27 pm

Get rid of the car loan - even 5 year CD's aren't paying 1.99%.
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Re: prepay car vs mortgage

Postby hand » Tue Jan 29, 2013 1:54 pm

Prioritize the car loan - cash flow improvement from paying off early comes in less than 56 months vs. 20+ years for the mortgage.
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Re: prepay car vs mortgage

Postby jda » Tue Jan 29, 2013 2:26 pm

Why car loan when mortgage interest is 1.01% higher?

Even assuming you can deduct all the mortgage interest at about 30% marginal rate, the mortgage rate is slightly higher than car loan (3%*(1-0.3)-1.99%) = 0.11%
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Re: prepay car vs mortgage

Postby Rodc » Tue Jan 29, 2013 2:33 pm

hand wrote:Prioritize the car loan - cash flow improvement from paying off early comes in less than 56 months vs. 20+ years for the mortgage.


This answers the question just before me.
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Re: prepay car vs mortgage

Postby ddunca1944 » Tue Jan 29, 2013 2:39 pm

I agree with paying off the car loan - the improved cash flow happens sooner. But, I'd (as you posted your intent) bump up the emergency fund to 6 months first.
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Re: prepay car vs mortgage

Postby Beantown85 » Tue Jan 29, 2013 2:43 pm

Another vote for the car loan. I would vote car loan even with 0 tax deduction on mortgage interest. The difference in the terms of these loans is far more significant than the difference in interest rate.
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Re: prepay car vs mortgage

Postby G-Money » Tue Jan 29, 2013 2:48 pm

jda wrote:Why car loan when mortgage interest is 1.01% higher?

Even assuming you can deduct all the mortgage interest at about 30% marginal rate, the mortgage rate is slightly higher than car loan (3%*(1-0.3)-1.99%) = 0.11%

In addition to the quicker realization of improved cash flow, there's also the spread.

Current yield on 5 year Treasury: 0.88%. Spread = 1.99% - 0.88% = 1.11%
Current yield on 30 year Treasury: 3.18%. Spread = 3.00% - 3.18% = -0.18%

The above assumes no tax deduction. The OP is paying a healthy premium to borrow the 5 year money in comparison to the risk-free rate, while the OP is actually being paid (relative to the risk-free rate) for the privilege of borrowing for 30 years. Once the short-term loan is eliminated, OP could reasonably decide not to prepay the mortgage at all.
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Re: prepay car vs mortgage

Postby ks289 » Tue Jan 29, 2013 3:02 pm

jda wrote:Why car loan when mortgage interest is 1.01% higher?

Even assuming you can deduct all the mortgage interest at about 30% marginal rate, the mortgage rate is slightly higher than car loan (3%*(1-0.3)-1.99%) = 0.11%


I also favor tackling the loan with the highest interest rate first. While the car loan has a shorter term and lower balance and will be paid off faster, using funds to pay down the higher interest loan first will SLIGHTLY decrease the time required to pay all the loans and the total interest paid.
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Re: prepay car vs mortgage

Postby Toons » Tue Jan 29, 2013 3:12 pm

Car Loan :happy
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Re: prepay car vs mortgage

Postby jmuc85 » Tue Jan 29, 2013 3:18 pm

Thanks all, car loan was what I thought but I needed some validation.
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Re: prepay car vs mortgage

Postby hand » Tue Jan 29, 2013 3:24 pm

ks289 wrote:
jda wrote:Why car loan when mortgage interest is 1.01% higher?

Even assuming you can deduct all the mortgage interest at about 30% marginal rate, the mortgage rate is slightly higher than car loan (3%*(1-0.3)-1.99%) = 0.11%


I also favor tackling the loan with the highest interest rate first. While the car loan has a shorter term and lower balance and will be paid off faster, using funds to pay down the higher interest loan first will SLIGHTLY decrease the time required to pay all the loans and the total interest paid.


You need to specify that this approach reduces nominal interest paid (which is really only of academic interest).

Without knowing future inflation rates, it is impossible to determine which approach will minimize real interest paid (what real people care about) and therefore which approach would be optimal over the long term.
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Re: prepay car vs mortgage

Postby ks289 » Tue Jan 29, 2013 3:52 pm

hand wrote:
ks289 wrote:
jda wrote:Why car loan when mortgage interest is 1.01% higher?

Even assuming you can deduct all the mortgage interest at about 30% marginal rate, the mortgage rate is slightly higher than car loan (3%*(1-0.3)-1.99%) = 0.11%


I also favor tackling the loan with the highest interest rate first. While the car loan has a shorter term and lower balance and will be paid off faster, using funds to pay down the higher interest loan first will SLIGHTLY decrease the time required to pay all the loans and the total interest paid.


You need to specify that this approach reduces nominal interest paid (which is really only of academic interest).

Without knowing future inflation rates, it is impossible to determine which approach will minimize real interest paid (what real people care about) and therefore which approach would be optimal over the long term.


I agree that when comparing using money to pay off debt vs invest, inflation rates and this analysis come into play.

However, when the discussion is limited to which debt to pay off first, please help me understand how paying off lower interest debt first can ever come out ahead - if we are strict and consistent about the dollar amounts that are being used. I'm not talking about cash flow/flexibility.
I don't see how you can avoid have a longer period of time paying off debt and more interest paid.
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Re: prepay car vs mortgage

Postby jda » Tue Jan 29, 2013 3:54 pm

hand wrote:
ks289 wrote:
jda wrote:Why car loan when mortgage interest is 1.01% higher?

Even assuming you can deduct all the mortgage interest at about 30% marginal rate, the mortgage rate is slightly higher than car loan (3%*(1-0.3)-1.99%) = 0.11%


I also favor tackling the loan with the highest interest rate first. While the car loan has a shorter term and lower balance and will be paid off faster, using funds to pay down the higher interest loan first will SLIGHTLY decrease the time required to pay all the loans and the total interest paid.


You need to specify that this approach reduces nominal interest paid (which is really only of academic interest).

Without knowing future inflation rates, it is impossible to determine which approach will minimize real interest paid (what real people care about) and therefore which approach would be optimal over the long term.


So basically it's a coin toss then?

The reason I asked the original question is because I fail to see why the car loan is the overwhelming favorite among the members here. To me the difference is pretty marginal and if op's goal is paying down debts then the end results should be fairly similar whichever route op choose to go with.
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Re: prepay car vs mortgage

Postby hand » Tue Jan 29, 2013 4:17 pm

ks289 wrote:
However, when the discussion is limited to which debt to pay off first, please help me understand how paying off lower interest debt first can ever come out ahead - if we are strict and consistent about the dollar amounts that are being used. I'm not talking about cash flow/flexibility.
I don't see how you can avoid have a longer period of time paying off debt and more interest paid.


Apologies, but I don't understand what you're getting at with your point about being "strict and consistent about the dollar amounts", but I'll give it a go anyway...

There is a difference between paying nominal interest (ignoring inflation) and real interest (net of inflation).

Imagine a scenario where inflation remains at 2% until the car loan is paid off, but then spikes to 10% for the remaining years until the mortgage is paid off.

In nominal terms, you are absolutely correct that paying off the car loan first is advantageous because the rate is higher.... but a nominal benefit is meaningless to a real person in the real world because they are subject to inflation.

In real terms (adjusted for inflation), the cost of the car loan is $0 (interest rate = inflation) and the cost of the mortgage is 1% until inflation spikes, and then is -7% annually (assuming a fixed rate mortgage).
Intuitively, it should be clear that it is worth it to pay 1% real interest for 5 years to be paid 7% interest for the remaining 25 or so years.

Because future inflation is unknowable, and this example is admittedly extreme, actual nominal outcome is difficult to predict one way or another.
In any case, cash flow considerations are typically more important to the borrower than a couple dollars of interest...
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Re: prepay car vs mortgage

Postby hand » Tue Jan 29, 2013 4:30 pm

jda wrote:
So basically it's a coin toss then?

The reason I asked the original question is because I fail to see why the car loan is the overwhelming favorite among the members here. To me the difference is pretty marginal and if op's goal is paying down debts then the end results should be fairly similar whichever route op choose to go with.


The disconnect is that you are looking strictly from a "which approach results in more money in 30 years " point of view (and possibly ignoring the impact of inflation).
Posters who advocated paying off the car loan are likely looking at this decision from an overall personal finance point of view and recognize the importance of cash flow / minimizing fixed costs.

In real life, people lose their jobs, have emergencies and other bad things happen - the lower their fixed costs and the better their cash flow, the more likely they are to be able to weather the storms.
This is why paying down the car loan and freeing up an extra $287 a month is such a slam dunk.


Note, this entire thread appears to assume a fixed rate on the 30 year mortgage even though this detail is not specified, though 3% seems almost too good to be true.
If the mortgage is an ARM, the decision gets more complicated...
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Re: prepay car vs mortgage

Postby jda » Tue Jan 29, 2013 5:07 pm

hand wrote:
jda wrote:
So basically it's a coin toss then?

The reason I asked the original question is because I fail to see why the car loan is the overwhelming favorite among the members here. To me the difference is pretty marginal and if op's goal is paying down debts then the end results should be fairly similar whichever route op choose to go with.


The disconnect is that you are looking strictly from a "which approach results in more money in 30 years " point of view (and possibly ignoring the impact of inflation).
Posters who advocated paying off the car loan are likely looking at this decision from an overall personal finance point of view and recognize the importance of cash flow / minimizing fixed costs.

In real life, people lose their jobs, have emergencies and other bad things happen - the lower their fixed costs and the better their cash flow, the more likely they are to be able to weather the storms.
This is why paying down the car loan and freeing up an extra $287 a month is such a slam dunk.

Note, this entire thread appears to assume a fixed rate on the 30 year mortgage even though this detail is not specified, though 3% seems almost too good to be true.
If the mortgage is an ARM, the decision gets more complicated...


Point taken, I just want to make sure it's not slump dunk like a lot of posters made it to be. Basically a lot of assumptions are being made such as future inflation rate.

I also want to point out if cash flow is important to OP and we agree inflation is going to be higher than both loans' interest rate than OP is better off not paying down the debt and save it for something else.
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Re: prepay car vs mortgage

Postby Snow Boarder » Tue Jan 29, 2013 10:19 pm

hand wrote:Prioritize the car loan - cash flow improvement from paying off early comes in less than 56 months vs. 20+ years for the mortgage.


+1
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Re: prepay car vs mortgage

Postby grabiner » Tue Jan 29, 2013 10:52 pm

ks289 wrote:However, when the discussion is limited to which debt to pay off first, please help me understand how paying off lower interest debt first can ever come out ahead - if we are strict and consistent about the dollar amounts that are being used. I'm not talking about cash flow/flexibility.


Because you will use the money faster, and thus avoid interest-rate risk. If you pay down your mortgage, you won't be adding to your cash flow, so you'll have to take out another loan (at a possibly higher rate) when you buy your next car. If you pay off your car loan, and then invest the money that would have otherwise gone to car payments, you will be able to pay cash for your next car.

In addition, if interest rates fall in five years (or you can afford a shorter-term loan at a lower rate) you can refinance your mortgage, and any prepayments will decrease the benefit from refinancing.
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Re: prepay car vs mortgage

Postby mshinde » Tue Jan 29, 2013 11:22 pm

If you are sure of your job and can afford few hundred dollars, why not change the loan to 15 yrs. Not sure how much better rate you can get, but even if its .25% you will be saving a lot in interest payments. This might bump your payments to 1600-1700 range and you can put additional 300$ towards car loan.
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Re: prepay car vs mortgage

Postby G-Money » Wed Jan 30, 2013 12:38 am

grabiner wrote:
ks289 wrote:However, when the discussion is limited to which debt to pay off first, please help me understand how paying off lower interest debt first can ever come out ahead - if we are strict and consistent about the dollar amounts that are being used. I'm not talking about cash flow/flexibility.


Because you will use the money faster, and thus avoid interest-rate risk. If you pay down your mortgage, you won't be adding to your cash flow, so you'll have to take out another loan (at a possibly higher rate) when you buy your next car. If you pay off your car loan, and then invest the money that would have otherwise gone to car payments, you will be able to pay cash for your next car.

In addition, if interest rates fall in five years (or you can afford a shorter-term loan at a lower rate) you can refinance your mortgage, and any prepayments will decrease the benefit from refinancing.

Also, even if rates stay the same, OP doesn't need to be stuck with a 30 year mortgage for 30 years. Right now, OP could probably get a 15 year for 2.75%, a 10 year for slightly less, or a 5 year for 1.99%.

With the car loan paid off, OP would have the flexibility to refi the mortgage to a shorter term with a lower rate. OP's DTI ratio will be much lower without the car loan. Without the flexibility of paying off the car loan first, OP might be stuck with a longer-term, higher-rate mortgage for longer, during which time rates might go up.
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Re: prepay car vs mortgage

Postby ks289 » Wed Jan 30, 2013 5:23 am

grabiner wrote:
ks289 wrote:However, when the discussion is limited to which debt to pay off first, please help me understand how paying off lower interest debt first can ever come out ahead - if we are strict and consistent about the dollar amounts that are being used. I'm not talking about cash flow/flexibility.


Because you will use the money faster, and thus avoid interest-rate risk. If you pay down your mortgage, you won't be adding to your cash flow, so you'll have to take out another loan (at a possibly higher rate) when you buy your next car. If you pay off your car loan, and then invest the money that would have otherwise gone to car payments, you will be able to pay cash for your next car.

In addition, if interest rates fall in five years (or you can afford a shorter-term loan at a lower rate) you can refinance your mortgage, and any prepayments will decrease the benefit from refinancing.


Excellent points. The reason I specified debt payoff discussion only is that I agree that there are major advantages to improved cash flow and opting to invest funds rather than pay off low interest long term debt when the effective interest rate is low or negative and refinancing if rates drop.
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Re: prepay car vs mortgage

Postby madbrain » Wed Jan 30, 2013 5:27 am

There is another thing to consider in the decision to pay off the car loan.

With 56 months remaining it sounds like it may be a fairly recent loan. Was it a 60 months loan originally ?
If you borrowed close to 100% of the car value, you may have negative equity on the car. Unless you have gap insurance, either from the finance company or from your auto insurance company, if you get into an accident and the car is totaled, the insurer will only pay you market value for it, which could be less than what you owe. You would be responsible for the shortfall. This may or may not be an issue when time comes to get a replacement vehicle. Possibly more so, if you have been putting every dime of your savings towards the mortgage.

If you do have gap insurance on the other hand, or you don't have negative equity on the car, this is not an issue.

I think given your relatively low current net worth, prepaying the car loan to improve cash flow is a good idea.

Personally, I take the opposite view. I have a mortgage with over $400k at 3.375% 30yr fixed, and $20k a car loan at 1.90%, and I'm choosing to prepay $1000 of the mortgage and $200 of the car loan every month. But I have a 7 figure net worth and I could pay off both loans in a few clicks, by liquidating about half my investments. I don't want to do that, though as I need those investments to work for me in order to retire.

But I also do need the mortgage payment to be gone in order to retire, and it's a big chunk, so I'm prepaying the mortgage faster. The house should last my lifetime given proper maintenance, whereas no car lasts forever, and even in retirement, I will likely have to buy another car or two. I don't view having a car paid off as any big achievement towards my retirement goal.

Another point for prepaying the mortgage is that you build equity which might be able to borrow against, and home equity tends to generally keep up with inflation over the long term. Whereas when you are paying off your car, it is still a depreciating asset, and if you are in a jam, you won't be able to borrow against it, and you likely can't sell it either because you need a vehicle to get around.
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Re: prepay car vs mortgage

Postby WHL » Wed Jan 30, 2013 11:35 am

I agree with the majority - pay off the auto loan first.

In my mind, getting rid of one monthly required payment is a huge benefit. It's reducing a mandatory monthly expense. It also allows for the redirection of those dollars to something else, either your mortgage or savings, or in my case, a savings account earmarked for my next vehicle purchase.

The marginal difference in interest rates between your two debts isn't a concern to me, as you'll have the auto loan paid off in a year.
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