Debt reduction/payoff.

[TrevorS]

Originally Posted By: TrevorS
Originally Posted By: 99Saturn
Think about the power of compounding interest over the term of the mortgage, IMO that is the seed supton is planting here.


Irrelevant.

Like I said you're overcomplicated this and missing the simple logic.

When paying off debt, reduce the balances with the highest interest rate first. You will immediately be paying less interest which means you have more left over to reduce the capital.

Simple example.

Car loan $20000 10% interest 5 years left
Mortgage $10000 5% interest 3 years left

Total $30000. Interest payment in total is $2000 + $500 = $2500

Say you receive a bonus of $10000:

Do what you say and pay mortgage off with $10000. Total interest left to pay = $2000 (car unchanged) + $0 (repaid mortgage) = $2000

Pay down the borrowing with the highest rate ie car loan and total interest is $1000 (reduced car loan) + $500 (unchanged mortgage) = $1500

After you pay the interest you have $500 more in your pocket which can then be used to pay down the car loan even faster.


Btw, take the above scenario and change any number you like apart from the interest rate. Put it in a spreadsheet and for simplicity's sake assume the loans are interest only (which is worse from a compounding perspective right?).

You won't be able to come up with any scenario where paying the lowest interest rate pays off your debt faster. You will always save more money in interest that will then reduce the balance of the highest interest rate debt faster. Even if you spend those interest savings you're better off as your remaining debt has a lower interest rate!

 

[supton]

Alright, you have my interest piqued. Out comes Excel. I used numbers near and dear to me: my own loans. $100k at 3%, 13 years left; and $15k at 3.5% at 4 years left. I'm being lazy and not analyzing the $10k at 0% and 3 years though.

Paying the mins means I pay $1100 to interest on the truck, and $21k on the house. If I were to magically have a $10k windfall today, putting $10k into the truck means I pay out $150 instead to interest, saving almost $1k. Putting that $10k into the house means I pay out a bit under $17k, or a $3k savings.

Scenario 0: $15k @ 3.5% -> $16,096; $100k @ 3% -> $120,888. Total = $136,984 spent.

Scenario 1: $15k @ 3.5% plus $10k balloon -> $15,150; $100k @ 3% -> $120,888. Total = $136,038 spent.

Scenario 2: $15k @ 3.5% -> $16,096; $100k @ 3% plus $10k balloon -> $116,483. Total = $132,579

Perhaps though I'm missing your point: if I pay off the truck and then use that payment into the house instead:

Scenario 3: $15k @ 3.5% plus $10k balloon -> $15,150; $100k @ 3%, plus $335 after truck payoff -> $115,015. Total spent = $130,165.

I think I see your point. [But that would assume no vehicle replacement over that nine year span of extra house payments. That seems unlikely.] Perhaps I'm trying to use a special case (windfall)?

 

[99Saturn]

Originally Posted By: TrevorS
After you pay the interest you have $500 more in your pocket which can then be used to pay down the car loan even faster.

Did you miss this?
Originally Posted By: 99saturn
To your point, still not the whole picture, as you have to do something with that savings from the car loan for the next 25 years and see what it's worth at the end of the same time frame.

Just to be clear, what happens if you use the numbers I laid out above and don't apply the last 3 full payments ($377.42) and the balance of the 57th payment ($77.85) to the mortgage?

 

[supton]

Originally Posted By: TrevorS
Originally Posted By: 99Saturn
Think about the power of compounding interest over the term of the mortgage, IMO that is the seed supton is planting here.


Irrelevant.

Like I said you're overcomplicated this and missing the simple logic.

When paying off debt, reduce the balances with the highest interest rate first. You will immediately be paying less interest which means you have more left over to reduce the capital.

Simple example.

Car loan $20000 10% interest 5 years left
Mortgage $10000 5% interest 3 years left

Total $30000. Interest payment in total is $2000 + $500 = $2500

Say you receive a bonus of $10000:

Do what you say and pay mortgage off with $10000. Total interest left to pay = $2000 (car unchanged) + $0 (repaid mortgage) = $2000

Pay down the borrowing with the highest rate ie car loan and total interest is $1000 (reduced car loan) + $500 (unchanged mortgage) = $1500

After you pay the interest you have $500 more in your pocket which can then be used to pay down the car loan even faster.


Scenario 0: $10k @ 5% over 3 years acrues $790, $20k @ 3% over 5 years acrues $1562, or $32,352 total.

Pretend extra $500/month.

Scenario 1: Pay off $10k faster. $31,236 spent.

Scenario 2: pay off $20k faster. $31,365 spent. Note: putting $500/month into this would pay it off faster than the $10k loan.

Scenario 3: Pay off the $20k faster, until interest earned is about the same (month 27). Then split the $500 until the $10k is paid off, then pay off the $20k. I come up with $31,309.

It would appear that you are correct.

 

[hattaresguy]

Originally Posted By: Win
Originally Posted By: TrevorS
....
Lol. Older folks (who saved) make up the majority of millionaires because of time and stock market gains. They don't have electronics because they're old!....


They're millionaires because they went out and made money, not because they sat around worrying about the cable bill.


They didn't have time to watch cable...

 

[bustednutz]

As the OP of this thread I have to say it has escalated far beyond what I thought it would.
Lots of really good info in here.

 

[dernp]

Here is a great website with numerous financial calculators:

www.dinkytown.net

 

[TrevorS]

Originally Posted By: supton
Originally Posted By: TrevorS
Originally Posted By: 99Saturn
Think about the power of compounding interest over the term of the mortgage, IMO that is the seed supton is planting here.


Irrelevant.

Like I said you're overcomplicated this and missing the simple logic.

When paying off debt, reduce the balances with the highest interest rate first. You will immediately be paying less interest which means you have more left over to reduce the capital.

Simple example.

Car loan $20000 10% interest 5 years left
Mortgage $10000 5% interest 3 years left

Total $30000. Interest payment in total is $2000 + $500 = $2500

Say you receive a bonus of $10000:

Do what you say and pay mortgage off with $10000. Total interest left to pay = $2000 (car unchanged) + $0 (repaid mortgage) = $2000

Pay down the borrowing with the highest rate ie car loan and total interest is $1000 (reduced car loan) + $500 (unchanged mortgage) = $1500

After you pay the interest you have $500 more in your pocket which can then be used to pay down the car loan even faster.


Scenario 0: $10k @ 5% over 3 years acrues $790, $20k @ 3% over 5 years acrues $1562, or $32,352 total.

Pretend extra $500/month.

Scenario 1: Pay off $10k faster. $31,236 spent.

Scenario 2: pay off $20k faster. $31,365 spent. Note: putting $500/month into this would pay it off faster than the $10k loan.

Scenario 3: Pay off the $20k faster, until interest earned is about the same (month 27). Then split the $500 until the $10k is paid off, then pay off the $20k. I come up with $31,309.

It would appear that you are correct.


I'm glad you decided to do the proof for this yourself. Its a good exercise to model numbers as you get to see how things work. I model all sorts of things, financial and non financial when it comes to making decisions.

Don't forget that the real interest rate on your mortgage includes the tax deduction so your savings by focusing on the car payment are relatively larger than what you calculated.

 

[artificialist]

Anybody a fan of Dave Ramsey?

Anyway, I have 1 debt, and that is my car. I chose something that I could stay in love with many years. If something big needed to be repaired, I would pay it and say it was worthwhile. This was after replacing a Saturn that had a failing engine at close to 100,000 miles. Sure, the body was okay, but why would I put so much money towards an engine rebuild if I didn't enjoy it?

 

[HTSS_TR]

Mortgage loan should not included in the debt, because of the potential increase in value.

If you buy a house at $500k, with $100k down and $400k mortgage. You sell the house 5-6 years later at $600-700k, total expense in 5 years: interest + insurance + property tax + maintenance ... Minus (income tax reduction + rent value) could be much less than the profit selling your house.

Also, owning the house has some value that can't translate to dollars compares to renting it.

But if you're unlucky buying the house at market peak and sell at a lost, then everything above is in the trash.

 

[TrevorS]

Debt is debt. The house will go up or down in value regardless of whether it has a mortgage on it!

You still should structure your borrowing to take advantage of the best rates. If your ARM Mortgage rate increases then apart from refinancing, you might need to pay down the mortgage before you pay down a car loan.

I take your point that if the value increases then the fact that you borrowed to buy it makes it like a leveraged investment and if you consider that profit, then you may well end up living there for free.

Right now consider that inflation is maybe 3% or more, certainly assets keep on increasing at that rate. And your effective interest rate after tax deduction is about 3%. If you plan to retire eg from CA to AZ, owning a house over a reasonable period is a great way to get there.

 

[JHZR2]

Originally Posted By: Quattro Pete
Originally Posted By: bustednutz
But right now I truly enjoy taking my Mortgage interest deduction. I really need it at my tax bracket.

So you enjoy spending a $1 in interest so that you can get 30-35 cents of it back at tax time?



Exactly! And the issue is that sure, one could put away a couple thousand that is equal to the monthly mortgage payment, but you're sitting on a huge chunk of money accruing interest. And so a higher yield on a couple thousand dollars a month is far less than mortgage interest on a few hundred thousand. Thus the "greener pastures" philosophy is not valid.

 

[99Saturn]

Originally Posted By: JHZR2
Originally Posted By: Quattro Pete
Originally Posted By: bustednutz
But right now I truly enjoy taking my Mortgage interest deduction. I really need it at my tax bracket.

So you enjoy spending a $1 in interest so that you can get 30-35 cents of it back at tax time?



Exactly! And the issue is that sure, one could put away a couple thousand that is equal to the monthly mortgage payment, but you're sitting on a huge chunk of money accruing interest. And so a higher yield on a couple thousand dollars a month is far less than mortgage interest on a few hundred thousand. Thus the "greener pastures" philosophy is not valid.


JHZR2 - I don't follow your math here. Say an extra payment of $1000 is made at the beginning on your mortgage that has a 4.5%/yr. rate, 30 yr. term (I'm seeing ~$2,813 savings on a $200K mortgage). Compare that to setting $1000 aside and investing in something that yields 6%/yr. Seems like in 30 years, you come out ahead with the 6%/yr. investment (~$5,743 at the end of 30 years). What other variables are you factoring in?

 

[Vikas]

If you can point me to "guaranteed" 6%/yr for next 30 years, I would be in your debt forever!

 

[supton]

How guaranteed does it have to be?

I have not followed how well Vanguard index funds have done, but I'd be tempted to put idle money there.

 

[99Saturn]

Originally Posted By: Vikas
If you can point me to "guaranteed" 6%/yr for next 30 years, I would be in your debt forever!

That would be a nice guarantee to have if anyone else has it, I'd love to know too (though I'd prefer 10% or 12%).

Here's one I find interesting - what if you were indexed in the S&P 500 over the last 30 years? Here's a dataset for the S&P 500 annual returns since 1928. As far as I can see, the worst return if invested for the full 30 years was the period ending in 57/58 - just under 8%. If you start to shrink that window, 25 years, 20 years, 15 years, etc. the possibility of a poor yield over the full time frame becomes more likely (ie, 25 year investment, lowest return looks like a 25 year run ending in 1953, 5.2%). Smaller intervals get worse. Certainly not a guarantee, particularly since one might touch the money for something over that time frame, or returns could simply get worse.

If I'm off in my math, someone please call me out. I'm looking at the geometric mean based on the link provided above over a 30 year look back.

 

[surfstar]

^That's the basic premise of a "lazy portfolio" - its time in the market that counts, not timing the market. Indexing pays well over time.

bogleheads.org is the BITOG for indexers

 

[JHZR2]

Originally Posted By: 99Saturn
JHZR2 - I don't follow your math here. Say an extra payment of $1000 is made at the beginning on your mortgage that has a 4.5%/yr. rate, 30 yr. term (I'm seeing ~$2,813 savings on a $200K mortgage). Compare that to setting $1000 aside and investing in something that yields 6%/yr. Seems like in 30 years, you come out ahead with the 6%/yr. investment (~$5,743 at the end of 30 years). What other variables are you factoring in?


Well, there is risk. As stated here:

Originally Posted By: Vikas
If you can point me to "guaranteed" 6%/yr for next 30 years, I would be in your debt forever!


Beyond that, very few are actually good at NOT spending what they have. Besides some forced things, like mortgages, people try to spend as much as they can/have. Why do you think we have become such a debt-filled, zero or negative savings rate, payment oriented society??? Its ALL about how much a month can you afford...

So I look at it like this... Someone thinks they can get a better return on money... Great... Especially if one has the discipline to actually save and get the return, then I agree that there is some niceness to doing this, because you do get the tax break (spend $1 to get 30c back), and the higher return. I have sincere doubts that many/most could actually do that. Remember that most tout the 30 year note vs 15 year because they want the "flexibility" to have freed up funds month to month. That does not appear to me to be disciplined investing...

But again, the problem is year by year. In year 1, a $100k mortgage at 4% on a 30 year note one pays around $3700 in interest. Someone with some free money, say $1000/month, yielding 6% return, might make $3-400 in that first year. So that $12000 could buy down the mortgage by over 10%, or make $360 in "higher yielding" investments.

Meanwhile, if one had this $12000 on their hypothetical $100k mortgage, they would have taken their 30 year down to less than a 8 year. And after year 8, then they are saving $1000/mo+mortgage paymnent into their higher yield investment from that point to infinity.

A higher mortgage balance and scaled or (more likely) less free money per month just makes the numbers worse for trying to make a handwaving argument about finding higher yields.

Most people spend their free money, not chase higher yields. Its human nature vs discipline. Im very anti-debt, and pro saving and investing, but I am, like everyone else, human. That said, I take the steps I can like avoiding revolvng debt and minimizing my mortgage term, so that if I spend too much, go on a long trip, or save a ton, Im OK.

Originally Posted By: 99Saturn

Here's one I find interesting - what if you were indexed in the S&P 500 over the last 30 years? Here's a dataset for the S&P 500 annual returns since 1928. As far as I can see, the worst return if invested for the full 30 years was the period ending in 57/58 - just under 8%. If you start to shrink that window, 25 years, 20 years, 15 years, etc. the possibility of a poor yield over the full time frame becomes more likely (ie, 25 year investment, lowest return looks like a 25 year run ending in 1953, 5.2%). Smaller intervals get worse. Certainly not a guarantee, particularly since one might touch the money for something over that time frame, or returns could simply get worse.



I think you answered your question. Returns are probably a bit higher when you consider reinvested dividends... But still...

And dont forget that you dont have the full principal invested in the index fund at the start of year 1, while you DO have the full mortgage note accruing interest at the start of year 1, and you pay precious little principal for MANY years.

 

[TrevorS]

Most should have after tax mortgage rates between 3% and 4%.

If that is not a good threshold to consider investing, then I don't know what is.

 

[JHZR2]

Nobody says it isnt. Its a matter again of how much in the first few years you have in the investment account versus the debt. If you have a non-trivial amount to invest, then you could pay the mortgage off MUCH faster and have a lot to invest with ZERO debt risk. If you have only a little, then you can get 6 or even 12% return, but the amount you are "earning" versus how much you are accruing and paying in interest (especially in the early years) is a huge delta.

And again, youre completely ignoring human nature and risk.