Guidelines for accelerated loan payoffs

If you've been frustrated with the faltering markets lately, as have most Americans, you've probably been discouraged from investing your disposable income into the stock market. That could very well be the correct choice for you and your family, depending on your financial plans and tolerance for risk. But if you're not investing in the stock market, what are you doing with all that money? Are you putting it in a savings account? Or a CD? Or are you paying down debt?

My personal financial plan calls on paying down my debt during the economic downturn. The markets have been unpredictable (and by unpredictable, I mean they're going straight down) and the amount of debt that my wife and I have will take a relatively short amount of time to pay off. We're hoping that when we're out of debt in a couple of years (excepting our mortgage), the market will be trending upward and we'll have a larger portion of our income to regularly invest, given the fact that we'll have no regular payments for our auto or student loans.

If you're going to start paying down debt in lieu of investing, consider the following three guidelines to help you prioritize where your money is being sent:

1. Pay off the loans with the highest interest rate first (as long as they're not tax advantaged)
Dave Ramsey will tell you to pay off your loan with the smallest amount first instead of the one with the highest interest rate. This adds a layer of subjectivity to your personal finance that, while making you "feel good" about paying down your debt, will cost you money. In a recent post, I discuss the financial disadvantages his plan.

Non-tax-advantaged loans that fall into this category include credit card debt, personal loans, and auto loans. Look for your highest interest rate, and start sending whatever extra money that you can to pay it off.

2. Pay off loans incrementally -- don't save your money and pay it off in one fell swoop
I'll give a personal example here. Though I still have a couple of years' worth of payments remaining on my auto loan, I'm hoping to have it paid off by January. While maintaining my "emergency fund" in my checking account, and have been placing my monthly disposable income into an "auto loan payoff fund" that lives in a savings account. Last I checked, I had a few thousand dollars in there.

I had originally planned to keep making my regular monthly payments and continue saving money in the payoff account until I had enough money to pay off the car. But then I crunched a few numbers and found the flaw in my plan. Here's how it goes:

Whenever you make a regular monthly payment on a loan, a portion of that payment goes toward the principal balance and another portion goes toward interest. Those percentages are determined by a couple of different factors:
1) the time left on the loan (the less time left, the higher the percent that goes toward principal) and
2) the amount of remaining principal balance (the lower the balance, the higher the percent that goes toward principal).

So if my monthly payment is $500, maybe $400 of that goes toward principal and the other $100 goes toward interest. Next month, after the principal balance has been slightly reduced, the payment distribution may be $405/95, and so on. But if I have a few thousand dollars in a savings account that's just waiting to be used to pay off the loan, I am better off sending that money as a principal-only payment immediately. If I reduce my principal by, let's say, $5,000, a much higher percentage of my regular monthly payment will go toward principal. If you're paying off a loan on an accelerated schedule, sending the extra money as soon as you have it instead of saving it and sending one big fat check at the end may save you several hundred dollars over the life of the loan.

3) After non-tax-advantaged loans are repaid, evaluate the tax benefits of other loans before repaying them.
Once your credit cards, personal loans, and auto loans are paid off, hopefully all you'll have left is a mortgage and maybe a student loan. At this time, before deciding to accelerate the payoff on these loans, you should reevaluate the stock market. Has it picked up yet? If you're still not feeling warm and fuzzy, do some math and figure out how much your tax-advantaged debt is really costing you.

If your mortgage has a 5% interest rate, remember that depending on your tax bracket, you'll get maybe 25 or 28 percent of that interest back in your tax refund. So think of the effective cost of the debt to be 3.75% (5%, minus 25% of the 5). Your mortgage is a very long-term loan, and you won't see the benefits of paying it down early for a very long time. Paying it off early won't reduce your monthly payments. Sure, it will be paid off sooner, but even if you double your monthly mortgage payment every month until it is paid off, it will take almost 10 years to pay off a 30-year mortgage. If the effective interest rate on your mortgage (the interest rate less the tax benefit) is only slightly higher than the amount you could earn in a CD or a savings account, I would rather see you hold onto that money just in case you need it.

With all loans, especially those that are tax-advantaged, the lower the interest rate, the less sense it makes to accelerate your payoff. My friend Quang's student loan has a 3% interest rate. I wouldn't pay that off early for the world. But the rate on one of my wife's student loans is 7.9%. I can promise you that as soon as my car is paid off, the next thing to go will be that sucker.

Non-tax advantaged debt is nobody's friend. If you're not satisfied with the performance of your investment portfolio, it could be a wise decision to pay it off early in lieu of investing. But if your only debts are mortgages or student loans, think twice before you start sending extra cash toward the principal. True, you're saving yourself money in the long run, but remember that you're also reducing your tax writeoff and parting with that money for a long, long time. And keep in mind: even if you're using the standard deduction (not itemizing), your student loan interest is still tax deductible!

Paying down that mound of student loans

A reader of my site sent me a private message describing an intimidating financial situation that she found herself in. After attending an expensive out-of-state college and starting grad school, she has found herself with $140,000 in student loans. Let me just say this: if your parents paid for your education, call them today and thank them.

I called her while driving back home from a business trip to talk it over. In this post I'll describe to you some of the specifics of her situation, some options that she was considering, the advice that I gave her, and the numbers that I crunched when I got back home, and my final conclusion.

Specifics:
Current sum of balances: $140,000
Current interest rate: varies; different loans have different rates ranging from 4.5% to 7.5%
Current salary: $60,000
Current credit: So-so, but her father has good credit and is willing to co-sign
Current living expenses: limited, as she is living with her grandmother

Options she was considering:
#1 - Buying a house and consolidating the student loan debt into the mortgage:
Her father suggested doing this, but she wasn't sure about her options. I can't say that this is not necessarily bad advice, but it really isn't an option. Here's why:

Depending on your situation, down payment, and credit score, mortgage lenders may be willing to give you some extra cash to help with certain expenses, like necessary repairs or closing costs. However, they're very careful about not giving you too much money, as they don't want the balance of the mortgage to exceed the value of the home because the home is used as collateral.

Mortgages tend to have lower interest rates than personal loans, credit cards, and student loan consolidations. That's because they present less risk to the lender because the loan is secured with an actual house. If you don't pay your loan back, the bank can seize and sell your home. The same goes for car loans. On the other hand, if you fail to repay your student loan or a personal loan, sure, the bank can destroy your credit, but they're S-O-L when it comes to getting their money back.

If my reader were to roll her student loans in with her mortgage, the balance on the mortgage would be $140,000 more than the cost of the home, less the down payment. So unless she was putting at least $140,000 down on the house, the bank would be "upside down" on her loan -- meaning they were owed a lot more than the collateral was worth. Banks don't like to be upside down, so her request would likely be denied.

On a side note, this type of lending and borrowing was a root cause of the recent economic downturn. People bought homes and assumed that, because of the housing bubble, the value of their homes would skyrocket and they would have incredible amounts of equity. Let's say I bought a house for $200,000 with no down payment. At first glance, I would have zero equity. But if after a couple of months the house was assessed at $300,000, my equity would be $100,000 and my bank would potentially loan me up to that amount in a home equity loan. This happened often and sounded great to everybody. But as home values eventually declined, all of that false equity diminished. All of the sudden, people that exercised these types of loans owed $300,000 on a home that was now only worth $175,000...but I digress.

#2 - Consolidating her private loans
My friend has a combination of federal and private student loans. Her federal loans are already consolidated at 4.5% -- a rate I wouldn't part with for the world. Her private loans (which I assume are the majority, given the high sum of her balances) have interest rates which vary from 6.5 to 7.5 percent.

This morning I looked into the cost of consolidating private loans. Turns out, it's more expensive than I had imagined. According to studentloanconsolidator.com, consolidating your private student loans will give you a variable interest rate from 7.9 to 11.93 percent and smack you with a one-time consolidation fee of 1-5%. I've got to say, that's pretty expensive! Of course, there are other options out there, but the consolidation of private student loans are very very expensive, especially considering my reader's current 6.5 to 7.5 percent interest rate.

The advice that I gave her on the phone:
When we spoke, I was in the car and didn't have time to research the total cost of paying back her loans or her consolidation options. I told her that consolidating her loans with a mortgage were simply not an option because she wouldn't have enough equity in the home. I told her to continue living with her grandmother as long as she could stand it and keep sending extra money to her lenders. I told her to start keeping track of her money -- how much she has, where it goes, etc, by using my favorite site on earth, mint.com. Finally, I told her to save a couple of months' pay in an emergency fund.

The numbers I crunched this morning:
Assuming a $140,000 principal balance, a 20-year payback period (common when it comes to loans), and an average rate of 7%, her regular monthly payments are probably somewhere around $1,085 per month. If I knew what her actual monthly payments were, I could be more certain about her average interest rate.

By paying that minimum payment each month, her student loans will be paid off in 20 years. However, if she sends and extra $500 per month toward the principal, her loans will be paid off in just over 10 years. If she can scrape together an extra $700 per month, the loan will be paid off in less than 9 years.

If some of her loans carried a higher interest rate, she could consider asking her father to take out a home equity loan for her. Because he's willing to co-sign on a loan, he's already shown that he's willing to put his credit and cash on the line to help out his daughter. Assuming that he owns his home and has considerable home equity, he could take out a home equity loan with a potentially low interest rate and pay off her student loans. The thing to consider is that home equity loans typically last for 30 years, so this would only be a valuable option for her if she were to 1) pay off the loan early and 2) obtain a lower interest rate than the highest of her student loan rates.

Final conclusion:
My friend is really in no position to purchase a home at this point. Her current student loans really resemble a mortgage. At her current income level, I would expect that she could afford a home worth approximately $140,000 to $180,000 dollars. But because her $140,000 in debt doesn't come with a house, she doesn't have the option to "live in her investment" or rent out a room. I would recommend that she refrain from buying a home until the balances on her student loans are cut down to at least $50,000.

If her student loans each carry different interest rates, she should start by paying down the one with the highest interest rate. Once that's paid off, she should start paying off the next one and the next one and so on. I recommend that she do this methodically and automatically by setting up regular payments with her bank. But she should make sure that the extra payments are going toward principal and not toward next month's payment.

An education is a valuable thing -- and an expensive one, too. Student loans are a part of life for many people, including myself, my wife, and many of our friends. By being smart about paying them down and using all of the resources available to you, you can bring your balance to a big fat zero in no time. Then, you'll be able to start saving that money for your own child's education!

To my reader that called asking for help: feel free to send me an email with the specifics of your loans. I've built some calculators that will help optimize their payoff, ensuring that in the end you're paying as little as possible.

What to do if you're upside down on your mortgage

Also see my related post: What if You're Upside Down on Your Mortgage and Need to Move?

A lot of blame for the housing crisis is placed on "sub-prime" borrowers and the banks that loaned to them. It is true that at one point earlier in the decade it was probably too easy for someone with bad credit to obtain a loan. But declining house values and the subsequent emergence of negative equity also affected many intelligent, well-educated homeowners with decent credit. Many of them Gen Xers and Gen Yers that were buying their home because they were entering the home-owning phases of their lives -- not because low-payment mortgages were falling from the sky like raindrops.
Many of these homeowners that are in trouble had simply overestimated their luck in hopes of making a good investment. I'm sure that many of them, before buying a home, analyzed the cost of renting vs the cost and appreciation associated with owning. Given the numbers at the time, buying made sense. Additionally, many of the homeowners in trouble believed their lenders were looking out for their best interests; a belief that was unfortunately discredited for thousands. And TV shows like HGTV's "My House is Worth WHAT?" gave intelligent homeowners false hope about the financial returns they could receive by spending thousands on home upgrades (and financing them with home equity lines of credit).
So if you find yourself in an upside-down situation, what do you do? Should you pay down your balance until your equity is positive? Not necesarily. You should treat your loan -- upside-down or right-side-up -- just like any other loan that you're considering to pay off early. The higher the interest rate on your loan and the lower the interest rate at which you can save, the more sense it makes to pay extra. But if you have a reasonable rate, let's say below 6.5%, I'd rather see you hold on to your money. Throwing more money at your morgage isn't going to increase the value of your home. Only time and inflation will.

If you're upside down on your mortgage, don't expect to be able to move anytime soon. Save as much money as you can in an interest-bearing savings account that is easy to access until the time comes to sell your house. If you're able to wait long enough, your upside-down issue will eventually correct itself. If you need to sell before then, your savings will enable you to send a heap of cash to your lender a week before the sale, bringing your equity back into the green in one fell swoop.
In the future, never forget the old addage "if it seems too good to be true, it probably is." I'm not saying that good investment opportunities don't exist. They certainly do. But truly exceptional opportunities rarely exist in the stubborn, slow, and steady real estate market. If you ever see your equity in your home growing faster and faster faster to a level that you can't believe, be cautious. It's like watching a racecar driving 300 miles per hour (they usually don't go much faster than 200). Sooner or later, it's going to crash.