Which Debts Should I Pay First?

Question

There are a lot of brilliant minds on here and I'd love your advice.

My wife and I have been debating which debts to pay extra money towards. Pay the highest interest first? Pay the lowest balance first to free up that payment? Don't pay extra to anything and save for another property?

Here are the debts:

$470k @ 4.75% -- two houses on one lot, live in one and rent the other. Pay a PMI of $200/mo until debt is down to $416k. I HATE paying PMI as it's just money down the toilet. But there's a long way to go until it's gone.

$257k @ 4% -- rental SFR

$27k @ 0.9% -- car loan

Knock out the car loan to free up the payments? Pay the $470k loan to get rid of the stupid PMI? Not pay anything and just save for another RE deal?

Thanks for your advice.

Jason Kosowan · Answer

Just my opinion - get rid of your PMI payment.

The other loans are lower percentage and you are getting equity out of each payment.  But, like another posted said, PMI is just a straight-up penalty and it doesn't increase your net worth when you pay it.

Jon Holdman · Answer

I think a primary residence is no less of a "doo dad" than a car.  Rest assured a house will depreciate just like a car without ongoing maintenance and updating.  Not as quickly, but I'm sure you've walked into a house that hasn't been updated and has received minimal maintenance for 30 years and thought "wow, what a disaster!"

Harry M. · Answer

Hey Scott,
Here are my thoughts on this:
- I would leave the rental and the car alone. The interest rates are low, and the money would earn a better return if invested in some good properties.
- Regarding the big loan, I would pay off the $54k responsible for the PMI only, and ride the rest of it out. The effective rate on that $54k is something like 9.2% (54000 * 4.75% = 2565/yr + 2400/yr for the PMI = 4965 / 54000 = 9.19%). In my mind, that's enough to make it worth paying off early.
That leaves you with the 416k at 4.75% and no PMI. That works out to 19760/yr in interest. I'm not sure it makes sense to pay that off early, especially given the amount of work it would take to get through that amount. For example, if you were to invest in more properties and were able to get a 10% cash-on-cash return (conservative), you would have to invest "only" 197600 in order to make 19760/yr in returns to offset the interest, as opposed to slogging through saving 416k.
If you were interested in keeping the loan around once you get it down to 416k, I would also looking at seeing if you can refinance it at that point, too. At 4.75%, the rate is good enough that I'd normally be happy with it, but given the large amount, even getting it to 4% would result in an additional 3120 per year in interest savings.
Anyway, hope this helps.
Best of luck with everything.
-Harry

Steve Babiak · Answer

Not sure if values are going up or down in your area, but I believe that loans usually say that once the balance goes below a certain percentage of an appraisal also.  So if values go up, you can get out of PMI with an appraisal.  It might be that the loan balance has to go below something like 82% of appraisal.  Check what your loan says.  My dental hygienist was happy when I suggested that approach to her a few years back, when values were up everywhere; no more PMI a whole lot sooner.

Josh R. · Answer

Well to each their own. Financing is a great tool for something that can produce income for you or appreciate over time. For me, I would rather not have a car payment and free up more of my biggest wealth building tool, my income. (To quote Dave Ramsey) something about not sending in $500 a month for a chunk if metal and plastic  that gets me from point A to B is liberating.

Tim Czarkowski · Answer

I agree I would either purchase another unit if it increases cashflow or go after the PMI.

Scott J. I completely agree if I can borrow money at 0.9% and invest it at 25%, that's a pretty nice spread. That's one of the main tenets of rentals; borrow long term with fixed rate loans invested into an asset with a higher return. As long as you are conservative with your estimates and reserves you will do much better over the long term. Some people like Dave Ramsey seem to be dead set against debt and I can understand their viewpoint to.

My Dad was complaining about my grandmother not wanting him to refinance his house even though it was a lower rate. I had to remind him that her mother went through the Great Depression and that obviously had an effect on how conservative she is. "Black Swans" occur much more often then they statistically should.

Scott J. · Answer

Great replies everyone. Sounds like paying down the big loan with the PMI is the way to go. Thanks for the reminder about getting it appraised again too.

Josh Rogan - I have the cash to pay the car in full. But at 0.9% it makes more financial sense to get the loan and put the money towards something with higher ROI, rather than pay cash for the car to "save" the 0.9% financing.

Josh R. · Answer

I would pay off the car first. Yes it has the lowest interest, but it also has the shortest term and likely the largest ratio of payment to total balance. The other option is sell the car and buy something you can afford to pay cash for. Never understood making payments on an item that depreciates as rapidly as a car. As Rich Dad would put it, that's a doo-dad.

Shari Posey · Answer

Steve has a good idea...I just had a client who bought this time last year with and FHA loan be able to refi with no PMI because the market has gone up and he did a little sweat equity on the property--it will save him BIG money each month.

Also, I believe in the debt snowball effect...start with eliminating the smallest balance and work your way up adding those payments to the next highest balance.

Jon Holdman · Answer

Two schools of thought.  You could call them the mind and the heart.

The mind says pay off the one with the highest interest rate.  In your case, PMI would come into play, too, since that's essentially an extra interest payment.

The heart says pay off the one with the lowest balance.  Once that's gone you can say "Yea, I had three bills, now I have two."

In your case, the interest rate on your highest one isn't too high, but it does amount to $1860 in interest per month.  Tack on the $200 in PMI and its bigger still.  But, as you point out, it will take a loooong time to make any significant dent.

Which Debts Should I Pay First?

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