Loan Payoff Efficiency

[Zachary C.]

So, let’s say I am considering the topic and idea of the prioritization of paying off loans.

To me, it only makes sense to consider the principle of the question for the initial prioritized list. I believe that consideration of individual circumstances could undoubtedly sway the order of the list. However, those should be regarded as secondary and only applied once a properly ordered list has been established based on the principle of efficiency.

The idea of efficiency, as I mean it here, is given a scenario with more than one debt, which should be the logical choice to focus on and pay off first? Secondary factors like how much I have available to pay down with (now or via monthly budget) or the opportunity cost (investments that could be made instead) must be eliminated so that only the efficiencies/deficiencies involved in the loans and their order of early payment are considered. There are too many possible scenarios that could be created with secondary factors which is why I think they should be considered after making a logical list; so that pros and cons of changing the order could be properly weighed. I hope this is a fairly logical approach to take as real life can change factors randomly and we must ultimately cope with that as required.

So, we must break down a scenario with only the essentials on the table:

We have some undefined amount that can be applied to one loan at a time (for the sake of focusing on the efficiency principle).

In addition to being an undefined amount it can also fluctuate in unknown amounts and directions (keeping real life involved).

All loans are assumed to be fixed rate and amortized.

All the loans are at different points in their life cycle of pay down.

The loans could have had the same, different, or mixed original amortization periods.

We will have 4 loans to prioritize (listed in no particular order) so we can work off the same example:

A) Remaining principle $94,925, Interest rate 3.75%, Monthly payment $710

B) Remaining principle $54,814, Interest rate 5.50%, Monthly payment $388

C) Remaining principle $12,741, Interest rate 3.90%, Monthly payment $532

D) Remaining principle $41,495, Interest rate 5.25%, Monthly payment $355

Given the above information:

Is there some fundamental flaw in looking at the question in this manner?

If so, what is it?

Is there enough information to make an informed decision regarding the question?

If not, what information would you still require to do so?

If so, how do you prioritize your list for efficiency AND how did you come to that conclusion?

[James Gates]

Hey Zac,

That is an awesome question and love the thinking behind the idea of optimizing loan payment. My initial thought, however, was "why pay down the loan?" Leverage leads to higher ROI's, which is the only number that at the end of the day matters. Inflation reduced, tenant destroyed, self-paying-debt is one of the primary wealth creators for investment property owners. I would be interested in graphing the ROI curve of each property, and find the peak of the graph, and at this point (usually 5-7 years in) I would look to strip/split the equity accumulated into additional properties. I would recommend this strategy for cash flowing stable investment properties only. 

Now, if the question about optimizing the debt were framed outside of "good debt," you would basically be looking at two schools of thought often brought up in the Personal Finance community. The "Avalanche Method" and the "Snowball Method (popularized by Dave Ramsey)." The Avalanche method would tell you to pay down the highest interest rate debt, regardless of the account balance. This will mathematically save you the most amount of interest in the long run, every time. This is the method I would recommend for financially literate, dedicated investors. This is mathematically the best choice. The Snowball method tells you to pay down the lowest account balance, regardless of interest rate. When that lowest balance is paid off, "snowball" the amount you were paying to that now-paid-off account into the next lowest balance. This method is mathematically inferior but tends to work on individuals who are greater affected by short-term behavioral changes (paying off debt feels good), and this is a majority of the people in this country (which is why Ramsey is so popular). 

I hope I didn't derail your question, I thought it might be helpful to put a few thoughts on paper and delve a little deeper into your thinking. 

Happy Thursday,

-James