Logic on deciding which loan to pay off


S

Sam

I was hoping to get some help on how to decide which of my loans to pay
off (or should I pay one off). So here are the three loans that I could
potentially pay off.

1. House A second mortgage (heloc): $24.5k, 8.0% interest (this is
rental house that is currently rented and generating positive cash
flow).
2. House B second mortgage (heloc): $24k, 8.75% interest (this is the
house I live in).
3. Automobile: $18k, 6.75% interest.

The monthly payment on the truck is roughly $50 higher than the helocs,
the interest rate on the truck is fixed. The helocs are 5/1 arms, I am
two years into one of the helocs and one year into the other. My main
goal is to reduce debt, reduce the amount of money I am spending on
interest in general and increase monthly cash flow.

My initial thoughts were to pay off one of the helocs, I really like
the idea of having one of those paide off. I am not sure if it makes
financial sense or not but I feel better about paying off the loan of
an appreciable asset rather than paying off a depreciable asset. After
putting all the data together in one place and thinking about this a
little more I think paying off the auto makes more sense for the
following reasons.
1. Since its monthly payment is higher than the helocs paying it off
would increase my monthly cash flow more.
2. The interest on the auto loan is not tax deductable and the interest
on the helocs are.
3. Paying off the auto requires less cash so that I can keep more cash
invested and earning interest.

Which brings me to my other issue, to pay off any of these loans will
require me to sell some stocks (reduce my investment assets so that I
will be earning less interest), the stocks are in a non-retirement
account so no issue with selling the stock. So does it make sense to
sell the stock to pay off the loan if my investments are currently
making a greater return than the interest being charged on the loans?
Also, these stocks to be sold represent my emergency cash so this will
greatly reduce my emergency fund. I guess the other mental problem I
have here is that if I sell the stock (an asset that is growing and
earning interest) to pay off the truck (an asset that that is shrinking
in value), so I am swapping an appreciable asset to for a depreciable
asset. That is a tough fact for me to swallow.

As a side note I should add that I do not have to pay off any of these
loans, nothing is forcing me to pay off the loan. At this point it is
something that I would like to do but it is not a necessity.

Any suggestions????

Thanks
 
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S

Sandra Loosemore

Sam said:
Which brings me to my other issue, to pay off any of these loans will
require me to sell some stocks (reduce my investment assets so that I
will be earning less interest), the stocks are in a non-retirement
account so no issue with selling the stock. So does it make sense to
sell the stock to pay off the loan if my investments are currently
making a greater return than the interest being charged on the loans?
Paying off a loan at 6.75% gives you a *guaranteed* return of that much.
You can't say that about stocks.
Also, these stocks to be sold represent my emergency cash so this will
greatly reduce my emergency fund.
If you pay off a loan, your monthly expenses will be that much lower,
so you won't need such a big emergency fund. It's generally not
considered such a good thing to keep your "emergency fund" in stocks,
either; what if you have an emergency when your stocks are down 20 or
30%? (Look at what the market did on 9/11 for an example.)
I guess the other mental problem I
have here is that if I sell the stock (an asset that is growing and
earning interest) to pay off the truck (an asset that that is shrinking
in value), so I am swapping an appreciable asset to for a depreciable
asset. That is a tough fact for me to swallow.
The real problem is that you *bought* the asset that is shrinking in
value to begin with. You have to pay for it sooner or later. If you
now think that wasn't such a great idea, can you sell the truck and
replace it with a less expensive vehicle? Or with your feet? ;-)

Personally, if it were me, I'd pay off and/or sell the truck and start
putting half the money you save on its monthly payment into a cash
emergency fund and half into paying off the 8.75% HELOC.

-Sandra the cynic
 
M

Mark Bole

Sandra said:
I agree with everything that Sandra wrote.

Further, I recommend a few other thoughts to toss into your stew of
"mental [obstacles ... that are] tough for [you] to swallow".

First and foremost, analyzing your options as you are doing is good, but
don't get stuck there. Paying down *any* of your loans, even partially,
is a good step. Like Sandra, I recommend just paying off the vehicle
loan and then plan to keep the truck for a good long time. But if not
that, your HELOC's (by definition) should allow for partial payments of
principal at any time -- so just pay down *something* by the end of this
year, and you really can't go wrong.

Second, stop trying to link specific dollars of debts to dollars of
assets. In general, you have short- and long-term assets (stocks,
vehicle, real estate), and you have short- and long-term debts (car
loan, mortgage). Whether or not a particular asset is appreciating or
depreciating (such as your rental real estate, which is doing some of
each) really has nothing to do with what mix of short-term vs. long-term
you want to aim for on each part of the balance sheet.

Third, you mention some tax issues, but that way lies a lot of number
crunching for perhaps very little benefit. Yes, your mortgage interest
is deductible and car loan isn't, but you mention stocks and then
interest income, which are taxed at different rates, depending on a lot
of other factors. You might easily run through five scenarios and find
that in the end, all external factors being equal, your difference in
net tax impact is negligible when spread over many years.

Fourth, why are you so concerned about increasing cash flow? That
should be a means to an end, not an end in itself. The goal depends on
the rest of your life circumstances (age, health, career prospects,
family and dependents, financial ties to your community).

-Mark Bole
 
J

John A. Weeks III

Sam said:
1. House A second mortgage (heloc): $24.5k, 8.0% interest (this is
rental house that is currently rented and generating positive cash
flow).
2. House B second mortgage (heloc): $24k, 8.75% interest (this is the
house I live in).
3. Automobile: $18k, 6.75% interest.
I look at it by the type of debt. A mortgage is an OK kind of
debt. It is better to not have to have one, but few people can
buy a house without one. At least the item behind the mortgage,
the house, generally holds its value over time.

A HELOC loan is a poor kind of debt. Mostly because people use
them to convert short term debt into long term debt, and convert
unsecured debt in a debt with your house pledged against it.

A car loan is an awful kind of debt. It is debt for an item
that goes down in value just by sitting, and an item that has
virtually no value in 4 to 6 years. You should never fall into
this trap.

So, my action would be to pay off the car loan first, then go
after the HELOC later on. An 8.0% HELOC isn't so bad if it is
fixed, but if those puppies adjust up, they start falling into
the high risk zone of interest rates. You don't want to be paying
10% for HELOCs.
I am not sure if it makes
financial sense or not but I feel better about paying off the loan of
an appreciable asset rather than paying off a depreciable asset.
I think you have it exactly backwards. I see it as OK to have
debt against something that holds its value, especially like
a house where you have to have shelter, and it sometimes even
goes up in value. A car is not an asset, it is an expense. Its
value withers away over time, so you never want to owe more than
what its current value is. If at all possible, you want to owe
less than its value so you don't get hurt so bad if the car is
wrecked.

-john-
 
J

joetaxpayer

Sam said:
I was hoping to get some help on how to decide which of my loans to pay
off (or should I pay one off). So here are the three loans that I could
potentially pay off.

1. House A second mortgage (heloc): $24.5k, 8.0% interest (this is
rental house that is currently rented and generating positive cash
flow).
2. House B second mortgage (heloc): $24k, 8.75% interest (this is the
house I live in).
3. Automobile: $18k, 6.75% interest.
Of course, we'd have to ask about the 'rest of the story'. Where do your
retirement accounts stand? Do you have a 401(k)? Is the employer
matching? Do you deposit enough to capture the match? Any Roth IRA?

For the above, both say "second mortgage". What about the first
mortgages? On the house you live in, is the first mortgage in line with
what's available now? (There are no point, no closing re-fi's, so
exchanging the rate you have for a better one, and maybe combine the
second into it is the way to go.)

To Sandra's point, there's a grey area where paying off doesn't make
sense, say a 5.25% fixed. We are in a part of the cycle where the risk
free rate is near or above that. But at 8.75%, I'm with her. And you can
always borrow the money back if need be. (As compared to the car loan,
once paid, you can't just write a check and get it back).

Without knowing the rest of the details, I'm in favor of paying off the
8.75 heloc early. Tell me your not making enough 401(k) deposits and
your employer matches the first 50% dollar for dollar, and I'm sending
you there.

JOE
 
S

Sam

Thanks for the responses guys, a different point of view was exactly
what I was looking for.

You guys had quite a few follow up questions and I will try to address
those here:

Sandra:
1. Good point about paying off a loan to guarantee a certain return,
that logic would seem to point to the 8.75% heloc, except for the tax
deduction which means I am not really paying 8.75%. How would I
calculate the actual interest rate after the tax break?
2. When I buy vehicals I try to buy the best quality I can with plans
to own for that vehical for 10 years. The last truck I had, which I
traded in on this new one, was a 1995 Dodge and had 220k miles. Buying
this new truck (by the way it was not *new*, it was a used truck even
though I refer to it as new) was not a luxury, the trade in value for
my old truck was $2500 and it would have cost me roughly $4000 to fix
all of the mechanical issues it was having.
3. Walking everywhere I go and/or using public transit is not an
option.

Mark:
1. I am currently paying against the principal of both the helocs, not
much but better than nothing.

Joe:
1. Retirement accounts, 401k contribution is 10% and I get the max
match. Also max contribution to Roth IRA every year for the past 7
years. I send $100/week to my brokerage company held in a money market
then use that to make the roth contribution within the first 2-3 months
of the new year. So I already have the 2007 roth contribution ready for
Jan 1st. The cash for the 2007 roth contribution is NOT what I was
considering to use to pay off the loan. I will be 33 in March and just
last week for the first time my retirement accounts closed above $100k,
I was pretty happy about that althought I do not know how that compares
to others in my age group.
2. I have not done any comparison shopping on current mortgage offers
so I am not sure how they compare to what I currently have. Maybe I
should do some checking on that.
3. Very good point about being able to borrow against the heloc if I
were to pay it off and not being able to borrow against the truck.

With everyones comments and my own thoughts, I think paying off the
8.75% heloc then using the additional cash flow to pay down the truck
and increase my emergency fund sounds like the best option.

Let me know if you guys have any additional comments and thanks for
taking the time to respsond.

Sam
 
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S

Sandra Loosemore

Sam said:
1. Good point about paying off a loan to guarantee a certain return,
that logic would seem to point to the 8.75% heloc, except for the tax
deduction which means I am not really paying 8.75%. How would I
calculate the actual interest rate after the tax break?
Do you have enough other deductions on your taxes to itemize even if you
pay off the HELOC? If no, your effective interest rate is the full 8.75%.
If yes, what's your tax bracket? Say you're in the 28% bracket; then your
effective interest rate is (1 - 0.28) * 8.75 = 6.3%. If your tax bracket is
higher the effective interest rate is lower, and vice versa.

-Sandra
 
J

joetaxpayer

Sam said:
Sandra:
1. Good point about paying off a loan to guarantee a certain return,
that logic would seem to point to the 8.75% heloc, except for the tax
deduction which means I am not really paying 8.75%. How would I
calculate the actual interest rate after the tax break?
Sam
see http://www.fairmark.com/refrence/2006reference.htm

it will give you the standard deduction (which, if you don't exceed by
itemizing, your interest rates are the real rate you pay) as well as the
chart for tax brackets. When you have a mix of deductible and
non-deductible loans, it's a good exercise to line them up, post tax.
There is a gray area, where one might tell you to pay off the $2000 left
on your 6% loan to free up that payment, i.e. pay the smaller amounts to
make faster progress. I respectfully disagree. I ask what is your post
tax interest cost each year, and what is the most expensive loan.

You sound like a saver with access to low interest money (i.e. not a
credit card). If you do itemize, and are in the 25% bracket, the B heloc
is costing you 6.56, and the truck 6.75. Too small a delta to call. Only
you can decide the value in accessing that money again.

Other than that, I believe you are on the right path. $100K saved if you
make $35-$40K/yr is on track. If you make much above 50-60K, you may
have some catching up to do. Of course that $100K ignores the equity in
both homes, so you may be way ahead.

JOE
 
Z

zxcvbob

joetaxpayer said:
it will give you the standard deduction (which, if you don't exceed by
itemizing, your interest rates are the real rate you pay) as well as the
chart for tax brackets. When you have a mix of deductible and
non-deductible loans, it's a good exercise to line them up, post tax.
There is a gray area, where one might tell you to pay off the $2000 left
on your 6% loan to free up that payment, i.e. pay the smaller amounts to
make faster progress. I respectfully disagree. I ask what is your post
tax interest cost each year, and what is the most expensive loan.

JOE

Since HELOC A was on a rental property (with positive cashflow even), would
the interest paid be a business expense on Schedule C even if he doesn't
itemize deductions? Or is just its first mortgage a legitimate business
expense? (maybe it depends on how he spent the HELOC money)

In any case, I vote for paying off HELOC B first, then apply the freed-up
cashflow to paying off the truck. Don't close the HELOC when it gets to
zero; you might need to tap it again later.

Best regards,
Bob
 
M

Mark Bole

zxcvbob said:
Since HELOC A was on a rental property (with positive cashflow even),
would the interest paid be a business expense on Schedule C even if he
doesn't itemize deductions? Or is just its first mortgage a legitimate
business expense? (maybe it depends on how he spent the HELOC money)
Mortgage interest on a rental property is a fully deductible expense on
Schedule E (not C).

Otherwise, mortgage interest on a primary residence and a second home
are deductible on Schedule A if qualified.

So yes, the tax implications of the two HELOC's should be taken into
account, which depends on filing status, state of residence, and so on.

-Mark Bole
 
J

johnrichardson_us

3. Automobile: $18k, 6.75% interest.
Something else to think about - is the Automobile loan a Rule of 78
loan? If so, paying it off early - unless it is really early - may not
get you as much as you think, since you've paid extra interest up
front.
 
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J

jIM

Sam said:
I was hoping to get some help on how to decide which of my loans to pay
off (or should I pay one off). So here are the three loans that I could
potentially pay off.

1. House A second mortgage (heloc): $24.5k, 8.0% interest (this is
rental house that is currently rented and generating positive cash
flow).
2. House B second mortgage (heloc): $24k, 8.75% interest (this is the
house I live in).
3. Automobile: $18k, 6.75% interest.


Any suggestions????

Thanks
2) (heloc on house you own) then


either
1) heloc on rental and 3) car
or 3) car and 1) heloc on rental

2) because this is highest interest and house you live in, make sure
you own this free and clear. Because this rate is adjustable and
higher, I am suggesting you pay this off first.

3) pay off car next, this assumes you can raise rent to account for any
changes in the adjustable part of this payment (if rate goes up, pass
this cost onto tenants).

1) pay off car. lowest rate, pay off last.

This reduces overall interest paid, without regard to tax deductions.
I am thinking of "risk"- because the car payment is not adjustable, I
am thinking it is the least risk to you to have this debt- car
insurance should also cover most of this if car is unusable (we have a
clause on our car insurance that the insurance will payoff the car if
in an accident).

I might suggest doing 2) and 3) at the same time- pay more principal on
both (maybe $100 extra on each per month). Then throw an extra $100
towards the heloc. When heloc is paid off, put all this money towards
car.
 

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