Question: Which debt would be better to prioritize paying off first, if I had some extra cash to allocate responsibly toward paying it off? My mortgage or my car loan?
We tend to carry a lot of them in our society. As per a 2017 report by GoBankingRates, the primary three types of debt that most individuals have are mortgages (65%), credit cards (50%) and auto loans (32%).
Usually questions like this are a no-brainer. Simply look to your loans with the highest interest rate and pay those off first. That means tackling your high-interest debt like credit cards and student loans.
However, when it comes to our mortgages and auto loans, the distinctions can be a little more nuanced. Due to the payments being spread out over a longer period of time, they are more manageable and the interest rates are frequently lower.
All things considered, debt is debt! The sooner you pay it off, the faster you’ll be able to emerge from under the mountain of interest that’s piling up on top of you!
But are there any other consequences to paying off your mortgage or auto loan that could make one option more appealing than the other for these two types of loans?
We’ll crunch the numbers and compare the true financial savings between paying off your mortgage and car loan in this post. But we’ll also discuss a few other important points that could improve situation and add to your decision. Let’s begin!.
Juggling multiple loans can be a real pain. Every month, they eat a big chunk of your paycheck, especially if you’re dealing with both a car loan and a mortgage – two of the biggest purchases most people make The combined balances and monthly payments can feel overwhelming.
But what if you could pay off one of these loans completely, freeing up a significant portion of your monthly budget? The question then becomes: which one should you prioritize – your mortgage or your car loan?
To answer this. let’s delve into the different approaches you can take:
1. The “Debt Snowball” Method: Pay Off the Smallest Balance First
This popular strategy focuses on tackling the loan with the lowest balance first. Any extra money you have can be applied to this debt to make it disappear quickly, providing you with a much-needed psychological boost and inspiring you to keep going.
Most people, unless they are almost done with their mortgage payments, will probably have the smaller balance on their car loan. Once your auto loan is paid off, you can apply that money each month to your mortgage, which will greatly expedite the mortgage’s payoff.
Benefits:
- Quick wins: Seeing a debt completely paid off early on can be a huge motivator to keep going.
- Simplified budgeting: You only need to focus on paying off one loan at a time, making it easier to manage your finances.
Drawbacks:
- Potentially higher total interest paid: If your mortgage has a higher interest rate than your car loan, you could end up paying more in the long run.
2. The “Debt Avalanche” Method: Pay Off the Highest-Interest-Rate Debt First
This method prioritizes tackling the debt with the highest interest rate, regardless of its balance. By doing so, you minimize the total amount of interest you pay over the life of the loans.
For example, if your mortgage has a high interest rate, it might make sense to pay it off first, even if your car loan has a smaller balance. This will save you more money in the long run, even though it might take longer to completely eliminate both debts.
Benefits:
- Saves money on interest: By focusing on the high-interest debt, you minimize the amount of money you’re throwing away on interest charges.
- Long-term savings: This approach can save you a significant amount of money over the life of your loans.
Drawbacks:
- Slow progress: It might take longer to see any significant progress, which can be discouraging for some people.
- Requires discipline: Sticking to this method requires strong financial discipline, as you might be tempted to pay off the smaller debt first for the quick win.
3. Keep Your Tax Breaks: Pay Off Your Auto Loan First
For many homeowners, this can be a major financial benefit, but did you know that you can deduct all or a portion of your mortgage interest from your taxes?
If you’re in a tax bracket where you can take advantage of this deduction, it might make sense to prioritize paying off your car loan first. This way, you can continue to enjoy the tax benefits of your mortgage while eliminating another debt.
Benefits:
- Tax savings: You can potentially save thousands of dollars by deducting mortgage interest from your taxes.
- Faster payoff: You can focus all your extra cash on paying off your car loan, potentially eliminating it quicker.
Drawbacks:
- Potentially higher total interest paid: If your mortgage has a high interest rate, you could end up paying more in the long run.
- Requires careful tax planning: You need to ensure you meet the requirements to claim the mortgage interest deduction.
4. Investment Alternatives: Spend Your Spare Cash Elsewhere
If your mortgage interest rate is lower than the average rate of return on the stock market (currently around 7%), it might make more sense to invest any extra cash you have instead of using it to pay off your loans early.
By investing your money wisely, you have the potential to earn a higher return than you would by paying down your debt. However, remember that investing always carries some risk, so this option might not be suitable for everyone.
Benefits:
- Potential for higher returns: Investing your money could potentially yield higher returns than simply paying off your debts.
- Flexibility: You can easily access your investments if needed, unlike with debt payments.
Drawbacks:
- Market risk: Investments can fluctuate in value, so there’s always a chance you could lose money.
- Requires financial knowledge: You need to have a good understanding of investing to make informed decisions.
Ultimately, the decision of whether to pay off your car or house first depends on your individual financial situation and goals. Consider the following factors:
- Interest rates: Which loan has the higher interest rate?
- Balances: Which loan has the smaller balance?
- Tax implications: Can you claim a mortgage interest deduction?
- Your risk tolerance: Are you comfortable with the potential risks of investing?
- Your financial goals: Do you want to be debt-free as soon as possible, or are you comfortable with carrying debt for a longer period?
By carefully evaluating these factors, you can make an informed decision about which loan to prioritize. Remember, there’s no one-size-fits-all answer, and the best approach for you will depend on your unique circumstances.
Here are some additional resources that might be helpful:
- SuperMoney’s guide on how to get out of debt: https://www.supermoney.com/debt-relief
- Reddit thread on whether to pay down the mortgage or car loan first: https://www.reddit.com/r/personalfinance/comments/1yp7ht/should_i_pay_down_my_mortgage_or_my_car_loan/
Freeing Up Money to Pay Your Other Debts
Forget the interest calculations for a second …
What if you could use the money you saved by paying off your mortgage or auto loan early to accomplish something else worthwhile?
What do I mean by this?
I’m talking about cash flow. What if our objective is to maximize the amount of money we have available each month to pay off our other debts?
This strategy is popularly known as the debt snowball method. The process is always the same:
- Debt with the lowest balance should be paid off first, regardless of interest rate.
- Now take the money you would have normally used each month to pay off Debt #1, and redirect it towards your debt with the next lowest balance (Debt #2). Continue until Debt #2 is paid.
- Repeat the process with Debt #3 and so on until all of your debts are completely paid off.
As you can see, this method produces a cascading effect whereby your payments compound until all of your debts are paid off while your budget remains unchanged.
So what does this mean for your auto loan vs mortgage dilemma?
The likelihood is high that the balance of your mortgage is less than the amount you still owe on your auto loan, even if you are unaware of your purchases. Therefore, with this strategy, you would:
- Make the most of your extra money to pay off the car loan as soon as possible.
- You continue to apply the same monthly payment amount to your mortgage after the auto loan is fully paid off.
I can tell you from personal experience that I have used the debt snowball method in the past and it works really well! I’ve paid off small debts that carried 0% interest just so that I could free up and extra $200 (or so) per month to use towards paying off our other expenses. Nothing feels better than completely paying off large loans!
Therefore, if your goal is to pay off your loans more strategically using a strategy like the debt snowball method, then in this instance, paying off your auto loan is the wiser course of action.
Auto Loan vs Mortgage – The Comparison
It’s helpful to comprehend how these loans are initially made before we can properly compare your mortgage and auto loan.
First of all, for both, most conventional loans work in a similar fashion:
The future value of the loan amount is calculated using a financial formula that accounts for two factors: 1) the predetermined annual interest rate; and 2) the length of time needed to repay the loan. This results in monthly payments.
The way the loan is constructed, the majority of your initial payments will go toward repaying the interest and less toward your principal. The ratios gradually shift over time, with more money going toward the principal and less going toward the interest.
In case you want to know, this is a process called amortization. It’s designed so that the lender gets paid their interest more quickly, while it takes you longer to pay back more of your loan.
What does this mean for you?
- By making extra principal payments, you can sway the amortization schedule to your advantage and ultimately pay less interest over time.
- Mathematically speaking, we can say that the loan you should accelerate is the one with the higher interest rate and the longer repayment period.
In this case, your mortgage.
But how much better is this really? Can we put some numbers behind it?
Let’s setup a real-world example of a typical auto loan and typical mortgage.
For the auto loan, using statistics from CNBC and Value Penguin, we find:
- Average loan: $30,032 (we’ll round to an even $30,000)
- Average monthly payment: $503
- Average term: sixty-eight months (we’ll use sixty months in our model).
- Average interest rate: 3. 93% for 60 months and 3. 78% for 72 month (we’ll round to 4%).
Similarly, for a mortgage, using data from Experian we find:
- $201,811 is the average mortgage balance (again, we’ll round to the nearest even $200,000).
- We’ll utilize a standard 30-year fixed rate mortgage with a 4-year term for our model. 5% APR.
Putting all of this together, our monthly payments equate to:
- Auto loan = $552.50
- Mortgage = $1,013.37
The final piece of the puzzle will be determining how much extra monthly we want to put toward our auto loan or mortgage. For this, I will select a simple amount of $100.
After running all the numbers through Excel, I arrive at the following conclusions after the five years:
Putting the extra money towards our auto payments saves us $531 in interest. Putting the extra money toward our mortgage payments has (so far) saved us $740 in interest.
Therefore, just as we assumed, paying down the mortgage was the better choice.
But take into perspective that this is only by a lead of $209 over a 5-year period. That means that, despite the mortgage’s small mathematical advantage, choosing to pay down your loan faster essentially has no bearing at all!
The fact that making faster mortgage payments will significantly lessen the amount of interest that borrowers will save over the course of the loan is one of the main arguments in favor of early mortgage paydown.
And they are correct. Early principal repayment will reduce your mortgage balance by years and tens of thousands of dollars. This, of course, depends on how much you pay and how often you make the payments. There are any number of mortgage payoff calculators across the Internet where you can see this for yourself.
What about our example? Based just on these first five years of our accelerated payments, how much money will we save over the course of our thirty-year mortgage?
The answer: $14,111
Again … not bad. But not exactly a great return either; especially not after waiting 25 years.
For instance, it would have been simple to create a third scenario in which we saved $100 a month for the first five years and invested the entire amount in an index fund for the stock market over the following twenty-five years. With an average annualized rate of 7%, it would have produced a return of $32,565. That’s double the interest saved over the life of the mortgage.
(Again, no surprise since 7% is a better rate of return than the 4. 5% interest rate on the mortgage. ).
Therefore, to sum up, even though there is a good chance that you will save even more money down the road by making accelerated mortgage payments, there isn’t a very compelling argument to prioritize paying off your auto loan with the extra money you save.
What other compelling reasons might there be in that situation, if the money saved doesn’t influence your decision?
Paying Off Car Loan Early | Principal vs Extra Payment Explained
FAQ
Should I pay off my car or home first?
How much does your credit score increase after paying off a car?
Is it smart to pay off car loan early?
Is it financially smart to pay off your house?
Should I pay off my car before buying a house?
There are many factors that lenders consider, but your credit score and debt-to-income ratio are among the most important. Paying off a car loan can help you improve your readiness for a mortgage, but it may not necessarily be the right decision. Here’s what to consider before you proceed.
Should I pay off my car loan first?
For example, if your mortgage has a high interest rate, it might behoove you to pay off this loan first, even if your auto loan has a smaller balance. If you do so, it will take you longer to clear both debts, but you will pay less money overall. The “debt avalanche” method can be tough to commit to.
Should I pay off my car early?
If you do plan on paying off your car very early, compare the cost of the fee to the overall savings of paying off your loan well before the final date. If the fee is more than the savings, it might not be worth it. 2. Your Money Might Be Better Used Elsewhere
Should I pay down my mortgage or pay off my car?
Putting the extra money towards our auto payments saves us $531 in interest. Putting the extra money toward our mortgage payments has (so far) saved us $740 in interest. Therefore, just as we assumed, paying down the mortgage was the better choice. But take into perspective that this is only by a lead of $209 over a 5-year period.