@pratik Option B is going to give you the largest return over time.
Option A makes your household finances less brittle: The lower the sum of all your minimum payments is, the less at-risk you are to every glitch in your income.
Option C could make sense if you're an investing genius who could earn a better return than the interest you're paying on your debts. As a practical matter, people who think they are investing geniuses almost never are. It could still make sense if your debts are at low, fixed rates (like student loans were in the 1970s).
Note that before doing ANY of these things, you should put enough cash in an emergency fund to cover a few weeks' expenses. This will help the "brittle household finances" issue even better than paying down debt, until you reach the point where you can pay off most of your debt.
@pratik The principal would be to pay off the one that will cost you more in the long run. So if A is more expensive in the long run, you would pay that down first. If B, then B. The “pay the higher interest loan” idea is based on the assumption that that’s the one that will cost more. That may not be the case in your situation.
@philipbrewer Thanks. Yes, I should have added that having an emergency fund should be the first priority. My rough calculation is 6 months worth of expenses in a cash or easily accessible/non-volatile account. And yes, I'm no investing guru. Far from it actually and doesn't help that I'm very risk-averse.
@pratik What @philipbrewer said! :) As one data point, our 'order of investments' is: 1) set up emergency fund 2) put 10% of income into retirement investments (Compound interest, yo!) 3) pay down non-mortgage debt 4) accelerate retirement investments 5) pay off remaining mortgage just prior to retirement.
@pratik @miraz yeah, it doesn’t match well with intuition. It seems like paying the bigger principal amount first would save you interest. The trick is that for a fixed payment amount, the proportional reduction in principal is greater if you pay off the smaller amount first.
Maybe an example helps?
Option A is $100 at 20% Option B is $1,000 at 10% Payment is $50
Applying $50 to A saves you $10 ($100x20% - $50x20%)
Applying $50 to B saves you $5 ($1,000x10% - $950x10%)
So, you save more money with Option A
@pratik This is a great discussion. Thanks for getting the ball rolling.
I tend to do what you explicitly forbid: hedge my bets between A and C, if B is paid off.
I came to financial competency late in life, in my mid 40s. A perfectionist mindset was part of the problem, until I came to the realization that there is no personal finance strategy that doesn’t include saving money. 😅
@pratik A few reasons. We believed our investments, compounded over time, would out-earn the benefit of paying off a low, fixed rate mortage early. Housing cost inflation and tax incentives make mortgage interest in the US even 'cheaper' than it appears on paper. Our non-mortgage debt (student loans, basically) had to be repaid, whereas mortgage debt could be eliminated at nearly any point by selling our house or downsizing to a smaller one. Our goals were also a factor. We wanted to retire early and travel, so ramping up our investments was more important to us than paying off the house.
@pratik Chiming in a bit late and the devil is in the details but... High interest short term debt is usually the most clear cut to pay down. Beyond that mortgage rates are below 3% now. As a long term couch potato investor there are only a couple of years out of several decades where I haven’t beaten that type of return by a substantial margin. Also I have always felt debt held in relation to an appreciating asset (like a house) is less disagreeable (that’s just a personal view).
We could pay off our mortgage and every year I analyze doing so because it sure would be nice to be debt free. But the reality is there is no economic reason for us to do so. Instead we take comfort in the large liquid cash pile we have instead. Also, we expect to sell before the mortgage runs it course.
@pratik Determine minium payments due on each bill. Pay the min on each, then funnel all extra money into your debt with the lowest cash flow index, which is the debt's balance / min payment. Interest rate is irrelevant. This way you improve your cash flow fastest and subsequently can pay off other debts fatster or do someting else with the cash if you like.
But just search for "cash flow index" a bunch of decent resources should come up.