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My wife and I have multiple loans to pay off: car loans, student loans, and a mortgage.

Currently we pay the minimum on all but one of the loans, and put any extra we'd like to pay into the highest-interest loan. We do this because, mathematically, it will lead to the lowest overall interest.

However, as a mathematician, I only know numbers. The real world is much more colorful and scary.

So is there some reason to pay more than the minimum on our other loans? For example: better for our credit score; legal reasons; some other benefit..?

BlueRaja - Danny Pflughoeft
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5 Answers5

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The reason to pay off a loan with a lower rate first is if there are thresholds involved. Also keep in mind you have to factor in if any of the loans are tax deductible.

What are some thresholds:

  • an amount that will allow you to drop PMI on the mortgage.
  • getting a loan to zero. This allows you to eliminate one debt which is a psychological boost. Paying off the debt allows you to snowball its minimum payment in to the other debts the following months.

You may ask why eliminate the single debt when it doesn't gain you anything mathematically. This goes in the some other benefit category.

mhoran_psprep
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mhoran mentioned PMI. One can look at a PMI encumbered loan this way: the rate on the loan is the mortgage rate for the lower 78% of loan to value. The rest of the loan has a true rate that has to include the PMI cost. Mathematically, it's as if you had two loans, a fixed rate, and a high priced second mortgage. If the $20k you need to pay down to eliminate PMI has a monthly $100 cost, the rate on that money should be viewed as 6% above the mortgage rate you already pay.

A credit card with too high a utization can ding your credit score short term. Regardless of total utilization.

Aside from these two issues, adjust the rates for taxes, eg my 3.5% mortgage is really 2.6%, and stick with the plan to sort by rate to pay off.

Too many expensive mistakes are made based on emotion. If you have the discipline of a mathematician go with the numbers. Keep in mind, millions 'feel' good about a tax refund. When anyone tells you they got a big refund, they are bragging they planned poorly, lent the government money interest free, and are too ignorant to understand either point. I always respond "that's great" and fake a smile.

The debt snowball method is a cult that may provide an emotional win. No mathematician should belong to that cult.

JoeTaxpayer
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Not any practical reasons that will make the higher interest cost worth it. If these loans all have a fixed rate, it makes sense to make larger payments towards the one with the highest interest rate.

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Be aware that if any of your credit cards has balances that are being charged different rates, then paying the minimum payment due shown on a monthly statement will almost certainly get applied to that part of the balance that is being charged the lowest rate (including a 0% rate if you accepted a 0% balance transfer offer or used one of those "convenience checks" that the card companies send their customers to use in creating a 0% rate balance). It is only any amounts that exceed the minimum payment due on a card that must, (by law), be applied to the highest-interest balance for that card. So, if the balance on a card has parts being charged different rates, it can be misleading to use an average interest rate for that card in making comparisons regarding which card has the highest interest rate.

Dilip Sarwate
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Check the conditions of each loan. There are plenty of credit cards where the interest rate changes, depending on whether you pay just the minimum, a higher amount, or a much higher amount. As a mathematician, you will enjoy that this makes the problem of optimal payment amounts much more interesting.

gnasher729
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