Paying off loans.. is confusingg?

Question

OK, I'm stupid at money, and I realize the banks have this warped system of how interest is applied to a loan. It seems all the interest is paid in the beginning of the loan, then by the time you have enough money to pay off the loan, there is no reason to since you are then only paying principal.

OK so my question is, how is this legal? It seems totally ******. The real reason I'm asking for help is, I have 2 loans: a school loan and a house mortgage. The school loan is 7.0% interest, and the house is only 5.25%. BUTTT... the school loan is halfway paid, and the mortgage is new, so I'm paying a much larger proportion of interest on the house payment.

So, I have extra money now, which do I pay toward first?

Answer 1

Ok, first, what you are doing is having a traditional loan that makes it seem like you are paying more in interest. What you are actually doing by having a traditional loan is paying the interest as it accrues and what ever is left over is applied to the housing loan.

For your main question, all of the financial advisers that I have read about all agree that you pay off your highest loans first than your lower loans next. The best way is to send in two checks. The first for the normal payment for your student loan than a principle only check that is applied directly towards your principle.

My suggestion is to see if you can not apply the extra money towards your retirement if you are not doing so already.

Answer 2

In general, loans are amortized and in order to make the payment to be a fixed amount, a bigger portion of the payment will be applied to the principal at the earlier stage of the loans.

In normal circumstances, you should pay down the loan with higher interest rate first (i.e. your student loan in this case). However, without knowing what type of loan you have for your mortgage (term and rate structure), there is no one who can give you the right answer.

If you have variable rate on your mortgage (e.g. ARMs), then, you should pay down your student loan first since your mortgage rate is lower. However, if it is a fixed rate mortgage, you will have to decide how much lower you think it will take you to pay off your student loan ... since the market is expecting interest rate to start going down early next year. Thus, if your student loan rate eventually goes below 5.25%, it would make more sense to pay down your mortgage first.

The simplest answer to your question is to pay down whatever has a higher interest rate.

Answer 3

You are not paying a higher interest rate in the beginning. You are paying the same interest rate the whole time, but since the interest is always a percentage of what you owe, it is higher when you owe more (when you first get the loan and haven't paid off that much yet). If you are paying more interest on the house now, pay your extra money towards that. Make sure you specify that you want the extra money to go towards the principal, not toward interest.

Answer 4

The first question to ask is how much did you borrow and what is the length of your loan. With those you'll be able to figure out which will be more beneficial to put more money toward. I'm inclined to say the house payment because it more than likely is a much longer term loan which would mean more interest in the end.

Answer 5

I'm not sure how school loans are treated by the IRS. If you don't get a tax deduction for the school loan, pay it down first.

A 5.25 mortgage is a good deal and IRS treatment of your mortgage interest payments will help you in April.

Answer 6

The "classic" answer is to pay the loan with the highest interest first. However, that's mainly applicable to credit-card debt, and not to amortized debt like mortgages and student loans. ("Amortization" is the word for the warped system that banks have. It applies to mortgages, student loans, and municipal bonds, should you choose to invest in some. And remember, the reason the pen is mightier than the sword is that it's being held by the people with all the money.)

In either case, though, every cent you pay over the standard monthly payment will go toward the principal. My recommendation: find a debt-reduction planner (the one included in Quicken is AWESOME; you may also be able to find one on a Web site somewhere) and work the numbers.

How the one in Quicken works: you enter in your debts, including the principal, the monthly payment, and your interest rate. Then you tell the planner how much extra you can put into it every month. And then it calculates what will get you debt-free in the shortest period of time and even produces an amortization schedule you can print out.

More than likely it'll tell you to pay off the student loan first, for several reasons. First, even though less of each month's payment is interest than your home loan, it's still at a higher rate -- meaning that as you pay the principal down each month, you're STILL saving interest money by reducing the principal in the long term.

Second, though, is that you're closer to finishing the student loan. So let's work with some made-up numbers here to give you the idea... Let's say you're paying $200 a month on your student loan of which $100 is interest, and you have a $1300 a month mortgage, of which $1.98 is principal and $1298.02 is interest. (Seems about right...) BUT -- your home loan has 357 payments to go, and your student loans only have 60 (five years on a ten year loan -- bear with me, I'm using simple, easy numbers, it's too much to ask them to be realistic too :-).

Now for various reasons you find that you can throw another $100 every month at your debts. Throwing that hundred bucks at your student loans is going to have you free and clear in about three years -- real ballpark-y figures here, but 36 months times $100 is $3600, and that's probably about within a couple really good dinners of half your principal on the student loan if the payments total $12,000 (60 times $200), cutting your time to payoff in half. With me so far?

Now... You've been chucking $300 a month at your student loans, it's the middle of 2009, and you're still paying $1300 on your house, but now you're up to a whopping $47 of principal and $1253 of interest. So suddenly you have this $300 a month with nothing to do... so you up your mortgage payments to $1600 and you're paying about $350 a month toward your principal.

Which means that in a year you've paid your principal down by $1700 over the minimum mortgage amount.

The last time I ran the Quicken debt-reduction planner with my own figures, it showed me how to end up owning my home in 14 years instead of 30, WITHOUT CHANGING MY CURRENT CASH FLOW -- simply by choosing what to pay first. And while the numbers were slightly different (mortgage, no student loans, a home-equity line of credit, and a couple of credit cards that are now down to ZERO!), the premise is the same:

Pay extra toward the highest-interest loan first, then put that money toward the next, and the next, till you're free and clear.

Oh, right, the other benefit is of course that your mortgage is also providing you with a tax break -- but only to the tune of the interest you pay. So one thought would be to adjust your withholdings to maximize your take-home pay (if you haven't already done that), then use that to pay down your student loans while you still are taking the top deduction for your mortgage interest. In a sense, your house pays for your college...

And right about now I feel like the guy at the beginning of Monty Python's "The Meaning of Life," when he says "We lease this machine back from the company we sold it to, thereby taking its cost out of the monthly operating expenses instead of the capital accounts."

In any event, that's the classic viewpoint of which to pay off first -- the highest interest, whether it's amortized or revolving.

Answer 7

When you make your house payment - regular one, you can add additional money to the payment. That "bonus" payment goes right to the principal. You lower the outstanding debt which in turns lowers the amount of your mortgage interest on each payment.
I am not aware of student loans work this way. They probably do.

Answer 8

Win on one

Answer 9

Get the lowdown here.