Why and How to Prioritize Paying Off Your Debts
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I love reading comments from others showing how they've been able to achieve their goals, asking an insightful question, or those wanting to offer a well thought out counter argument.
It makes Couple Money a stronger site and more useful. I want to thank all of you who take the time to leave a thoughtful comment.
Paying Off Your Debts is More Than Just the Numbers
Sometimes, though, I get comments from people who are less interested in money and who would rather tout about their ideas while putting others down.
As I was reviewing comments from readers on different posts yesterday, I came across this gem from my post on how to pay off a car loan:
If you find extra money every month, why sink it in something like a car note?
Just keep paying the car note as scheduled and put that extra money towards your mortgage…or invest it…idiots
First, let me start with two observations:
- Where are the numbers?! Jason seems to lack any examples pointing out why anyone would try his method out.
- “Idiots” comment: I expect people to disagree over finances, but Jason using ‘idiot' makes him seem surprised that anybody would handle their finances in a different way
I usually delete and forget comments like Jason's, but I thought that addressing a few points would be beneficial for people really interested in making their money work for them.
Prioritizing Paying Down Debts
The best place to start is by looking at the numbers and then move on to some other reasons why we chose to eliminate the car loan.
Total Purchase Price
Whenever someone has a loan, especially when it's a big purchase like a car or a house, it seems to be human nature to look at the monthly payments rather than the total costs of the purchase.
However, that's a very limited view.
I got the car loan for about $10,000 at an interest rate of 13.75%. If you're not familiar with car loan rates, it's pretty bad.
(That rate and the fact they wanted a co-signer should have been a clue to not go for the loan. I've learned since then.)
The monthly payments were about $230/month, which is a doable amount for some.
If we would've followed the schedule for the car loan, the total paid (including interest and those wonderful financing and dealership fees) would've come out to $15,962.
That's just ridiculous. The money spent on interest alone could be put to much better use.
Paying Off Your Car Loan vs Paying Off Your Mortgage
Since we didn't have a mortgage loan at the time, I'll be using the average rates advertised when we paying off the car loan (around 6.5%). With 13.75%
I received for the car as an example, we came out ahead financially by paying the car loan down instead of using for a mortgage.
Here's an example:
You have a 30-year mortgage at 6.5% fixed rate with monthly payments of $632.07. You also have a 5-year car loan at 13.75% (I'm ignoring the extra fees for simplicity) with monthly payments of $232.You have an extra $75/month to use.
Let's run the numbers –>
- If you paid the car loan off sooner, you will pay off your car loan in 3 1/2 years (at a total of $12,595.80). If you redirect that car payment towards your mortgage, you'll pay it off in just under 16 years (for a total of $165,865.25). The total paid for both loans would be $178,461.05.
- If you put that money towards your mortgage, you will pay off your car loan in 5 years (at a total of $13,867.66). If you redirect that car payment towards your mortgage, you'll pay it off in 16 years (for a total of $166,211.97). The total paid for both loans would be $180,095.28.
Paying the car loan down first will help you save money and just a bit more on time.
Paying Off the Car Loan or Investing for Retirement?
The second suggestion Jason offered was investing that money instead of paying the car loan faster.
That's a possibility that could've led to higher returns on, but not guaranteed. For our specific case, putting money towards a 13+% loan was financially better than hoping the market would exceed that.
What if we had a lower interest rate? Would investing make sense? It could, but one advantage of paying off the loan is that once it's paid you can use the entire monthly amount to invest as you please.
For example, that extra $50 that you used for the debt snowball now becomes $280 ($230 from car loan + $50)/month.
I think depending on the interest rate of the car loan, an argument could be made for investing.
Why We Decided to Pay Off the Car Loan Sooner
Now that we covered Jason's ideas on the topic, I want to address why we personally decided to pay off the car loan faster – both the numbers and the reasoning behind it.
Financial Security
Whenever you have a loan to repay, you're now more dependent on others – you need to keep your job to pay it (and your other bills), so you stay later to make sure you don't get laid off (which isn't entirely under your control).
We made a goal to keep our necessary expenses to be under one of our incomes. That way, if one of us needs to quit a difficult work environment, we have the freedom to do so (this actually happened).
Having peace of mind due to how we handle our finances is a plus for us. I'm not the only one.
Another reader who commented on that same post shared his story:
I felt as though this was impossible on a part time pay of $220.00 a week and two car notes.
My fiancé and I both worked at the same company and both lost our jobs during a merger.
I was lucky to find work and she hasn't just yet we didn't get unemployment (fighting the case for wrongful termination), but with a vehicle
Yea I know I was stupid and desperate my 2002 PT Cruiser is costing me $180.00 every two weeks plus gas and full coverage coming out to about $450.00. Then comes my fiancée's car -2005 dodge with a note of $279.86 a month.
Happy to note that Henry and his fiance were able to get their situation squared away.
Even if you can ‘afford it', lowering your obligated monthly expenses is a wise move in the long run.
Figuring Out Your Mortage
I also want to point out to Jason that we didn't have a mortgage at the time because we knew that having that debt over our heads would make us less financially attractive to potential lenders.
Mortgage lenders want to know that you can make these payments.
They look at borrowers debt to income ratio and by not having a car loan we were about to get a competitive rate when we applied.
When we were house hunting, we also made the choice to focus on only one income. For us, it meant that we focused on keeping the numbers based on net pay, not gross income.
While we could’ve looked at more houses in “our price range”, we decided to stay within our self-imposed limits.
It gave us a measure of comfort, knowing we were having a bit off buffer with our finances.
Thoughts on Paying Down Debts
I have nothing against investing. In fact, we still contributed while paying down debts, getting employer matches when available.
It's just that we wanted to balance it out with taking care of our family's cash flow.
I'd love to hear your thoughts on paying down debt versus other financial goals. How much do you factor cash flow for your decisions?
This article was originally publish in 2012. It was updated January 2022.
I honestly do need to invest more, but right now I’m more concerned with my debt.
I think debt should always be paid off before investing. Being free of debt is freedom to leave a job if you hate it, or try something new.
You mean personal finance is personal? Go figure. It makes sense to get a return of over 13% without risk. Any “idiot” can see that! For me, it doesn’t make sense since my car is financed at zero percent. There is that personal thing again.
Great job on the 0%! I think it’s hilarious when people don’t acknowledge that personal finance is more than numbers (though numbers do help 🙂 ).
You need to do things your own way and not listen to the naysayers. Following your own instincts leads to more confidence in your decision-making skills and that’s your insurance for success!
I agree with Stephen, paying off debt before investing makes the most sense.
I’ve never had a car loan and I’ve owned cars for nearly 40 years. My current car I bought when my son was 3 years old, he’s now 16. It has 230,000 miles on it and so I’m thinking about what I might buy next. Having a ‘car fund’ helps with purchasing a car outright vs. a loan. This is where the ‘paying off debt vs. investing’ diverges for me. I put funds into my ‘car fund’ regardless of what other debts we might have. I realize this may not work for everyone. I don’t attach who I am to what I drive. I do not see my car as a status symbol nor do I have fears about break downs. My car is a 1994 Volvo wagon and although I’ve had my share of repairs lately it’s still costing me far less than a new car.
I appreciate how you’ve broken down your example Elle. It helps to do this (as you said) whenever you’re making a large purchase. I still think the best way is to save up and pay cash but then I was likely raised in a different era then most of your readers. Using this mindset, we wouldn’t be experiencing the foreclosure catastrophe that we’re going through right now . . .
There’s a great invest-vs-mortgage calculator here: http://www.planningtips.com/cgi-bin/prepay_v_invest.pl. It’s essentially a fast & easy amortization calculator that compares the overall payments to a debt (doesn’t have to be a mortgage) vs. what your expected return would be if you were to invest your extra money instead. Granted, there are a good deal of variables, but if you make a couple of calculations, you can get a good idea of what would work out best.
I’ve done a mix of paying down debt & investing, and I have to say, that doing BOTH is important. That compounding growth over time is key when it comes to investment, so if I were to wait until all our debt was paid off before we invested, we’d be in a world of hurt come retirement time. In general, unless your debt is at a higher interest rate than your expected return on investment, or unless you have a TON of extra cash to throw at your debt & pay it off super-quick, it’s best to invest your extra money.
There’s also something to be said for cashflow. We recently paid off my husband’s car loan even though it was the lowest interest rate debt that we have – we were able to get rid of one of our largest monthly debt payments and free up extra cash to throw at our mortgage & to put towards extra student loan payments.
Like Darris, I also have a few savings funds where I set aside earmarked cash – car repairs/replacement, household repairs, Christmas/birthdays, vacation, tuition/loan payments, and a “slush” fund (where any extra money awaiting a purpose goes). I may not make a lot on these savings funds – less than 1% – but it makes me feel better to know that I have these items taken care of already with small, automatic, weekly withdrawals. No more having to scrounge up money for unexpected costs or having to float these items on credit cards has me feeling much more financially secure.
I agree with Stephen, paying off debt before investing makes the most sense.
I’ve never had a car loan and I’ve owned cars for nearly 40 years. My current car I bought when my son was 3 years old, he’s now 16. It has 230,000 miles on it and so I’m thinking about what I might buy next. Having a ‘car fund’ helps with purchasing a car outright vs. a loan. This is where the ‘paying off debt vs. investing’ diverges for me. I put funds into my ‘car fund’ regardless of what other debts we might have. I realize this may not work for everyone. I don’t attach who I am to what I drive. I do not see my car as a status symbol nor do I have fears about break downs. My car is a 1994 Volvo wagon and although I’ve had my share of repairs lately it’s still costing me far less than a new car.
I appreciate how you’ve broken down your example Elle. It helps to do this (as you said) whenever you’re making a large purchase. I still think the best way is to save up and pay cash but then I was likely raised in a different era then most of your readers. Using this mindset, we wouldn’t be experiencing the foreclosure catastrophe that we’re going through right now . . .
At an interest rate of 13%, paying down the car note would be a no-brainer for me. If it were lower, in the 3-5% range, then it would come down to your skill as an investor.
Personally, I think you absolutely should invest *before* paying off your mortgage. The money you invest *now* has more time to compound. But like Cash Flow Mantra said.. it’s personal!
I think that you are absolutely right to pay down debt before making a major investment. Not only will less debt increase your monthly cash flow, it will also likely improve your credit score.
This year, we are snowballing over $25,000 in debt. We are still (modestly) saving for retirement and a first home, but our decision to do so was definitely motivated by the Australian government’s taxation policies and co-contribution benefits. For instance, this year the government will put an extra $1000 in my husband’s retirement fund and contribute $2000 to our First Home Saver Account. Even though we have debt – and a plan to pay it off – that was just too much money to leave on the table!
I really like the way you broke down your decision on which debt to pay down. I understand that with mortgage rates at or under 4% now, people are choosing to invest over paying down their mortgage, but investing over paying down a 13.75% car loan? There is very little math I could do that would make that one make sense.
I also really like your point about cash flow – that’s one of the aspects that makes buying a condo and paying down the mortgage appeal to me (over renting a comparable apartment).