All of these are hypothetical numbers but I wanted to get an understanding of what makes more financial sense:
Say you have a 30 year fixed 4% $300,000 mortgage @ $2600/month (this includes P&I, taxes & insurance, PMI)
One car with $5000 balance remaining and $350/month payments (around 14 months remaining)
$10,000 in bank, and want to lower the monthly payments as much as possible for as long as possible on the mortgage.
Two options that occur to me:
1)Keep the $10,000 in the bank, use $300/month from this towards the mortgage - resulting in $2300 payment a month. This scheme would last for ~3 years, would replenish the initial capital with any tax refunds at the end of the year.
2)Pay off the balance of the $5000 car, use the $350 from that towards the mortgage, and use the remaining $5000 to pay $300/month towards the mortgage. This would result in a $1950 monthly payment and would last ~ 1.5 years (plus any tax refunds that are added to it).
Using the $10,000 to pay down the PMI only results in a savings of about $50/month, so that is out. Refinancing is not an option.
What makes more financial sense? Are there any other ideas that come to mind?
Pay off the car, and get rid of that debt. Use the $350 to build up an emergency fund large enough to cover 3-9 months of expenses, based on your comfort level. Once that is done, use the extra $350 towards retirement, if you aren’t doing that already. If you are, use it toward your mortgage.
Remember to start saving cash toward your next car.
What’s your interest rate on the car loan? Assume you’re getting 1 percent on your savings. If your car loan is higher than 5 percent (i.e., the 4 percent you’re paying on your mortgage and the 1 percent you’re receiving on your savings) it makes sense to pay off the higher interest loan.
Don’t, however, dip into your savings so deeply that you don’t have a cash reserve.
Assuming you have your emergency fund and 401K or similar funded at max contributions now and that the car loan has a higher interest rate.
Use the 10K to pay the car off. Any left from the $10K use to pay down the principle of the mortgage. Then use the money that would go to the car as extra principle payments to the mortgage.
And if you have equity in your house, consider getting a line of equity based on that equity. This will most likely give you the lowest interest rate for a car loan when you buy your next car. It can also be a source of emergency cash if you lose your job down the road.
Ignoring risk, you come out relatively best by paying down your high interest loans before your low interest ones.
Your home loan carries an interest rate of 4%. Your car loan carries a 0% interest rate ($5000/14 ~= $350). Your bank account likely accrues 0-1% interest per year. Thus, you should use your $10,000 to pay down principle on your home loan. In the future, you should also put any extra dollars into paying down additional principle, as your gains here outweigh the 0-1% you could gain on your bank account. You should not attempt to pay off your car loan early since it is a free loan. This is all assuming you are not subject to prepayment penalties for paying off principle early on your mortgage.
Again, the above ignores risk considerations. In reality, it’s a bad idea to have no savings. There are ways to earn more than 4% on your $10,000 by accepting additional risk, and this needs to be weighed against the safety of simply paying down your home loan. There are potential psychological advantages to having your car loan paid off. And so on.
But you can’t ignore risk. The first thing to do is to decide how much ready cash is needed for emergencies. That should be parked in the most liquid (and safe) account paying the highest interest rate you can find, which is probably not a bank account.
After that, pay off the highest interest loan first, which you say is the car loan, though the numbers don’t work out. Remember, the car loan does not give you a tax break, and the mortgage does, so the effective interest rate on the mortgage is not quite 4%.
Then, keep the car as long as possible and use the payments to either replenish your savings or reduce your mortgage, depending on your forecast of big ticket items or repairs in your future and your employment situation.
Never underestimate the value of being liquid. What I would do?
Make the car payment out of the $10k. That saves $350/mo, but still lets you keep the better part of that $5k for next 14 months in case an emergency comes up. Try to save at least $50/month out of that so that at the end of 14 months you have $700 worth of “free” money. Can you save $100? That’s $1400 “free”.
The last thing I would do, personally, is to spend a large portion of the $10k. If you are unfortunate enough to have the boss come to you on Friday and tell you that your services are no longer needed, then having that $10k will help you sleep much better. I’ve been there.
Why is it out? Paying down $10,000 on your principal is probably the best use of your money right now… if your interest rate is 4% then that’s as good as parking it in a 4% CD (and good luck finding a 4% CD any time in the next 4-8 years).
Of course if your car loan rate is higher, then that’s what you should pay off. My main point is your long-term result is better from making early payments against your highest interest loans. I wasn’t totally clear from your OP whether you were dead set on trying to improve your monthly cash flow, or trying to maximize long-term savings.
Check your mortgage to see what you CAN prepay. Many allow up to 5% or 10% principal paydown each year; certainly you should be able to apy down any amount if it’s up for renewal.
Paying $10,000 on the mortgage saves you 4% a year over the next 30 or so years. ($400/yr, $33/month or so). More, if interest rates, currently at a record, low start to rise. How long is your rate locked in?
Paying off the car only helps your long-term situation if you reapply the car payment money to the house, or if you can’t, save it and apply it to the house principle when you can… or (less profitabl) save for your next car to get ahead of the curve.
The bit about the house equity line of credit is good, if it will give you a good interest rate; the best of both worlds, put liquid cash into the house, use it for essentials like a new car on demand.
I would be leery about using a HELOC to purchase a car. If all goes to hell, you have put your house up as collateral for you car. By taking out a loan for the car, in a bad scenario, you could pay your mortgage and let the car get repossessed. With a HELOC, if you don’t pay EiTHER of your bills (car or mortgage) you lose your house.
If you have $10,000 is savings and a $2,600 mortgage, then you don’t have any left to spend on anything. You’re already waaay short of the necessary 6-month savings level.
If you’re actually saying that you have $10,000 that you can spend (and that the savings exist but aren’t mentioned here), then you should pay off the highest interest rate first in order to maximize your long-term assets.
If you want to maximize your monthly cash flow, figure out for how many months you want to do that and then we can tell you. For example, if for only one month, you can just pay yourself all $10,000 at once. If for many months, then you’re approaching my second paragraph (maximize long-term assets). I’m not sure where the middle line is.
In this scenario I would pay off the car and put that money towards the mortgage monthly. I would save the remaining cash for car or house repairs. If your mortgage is fairly new and you really don’t need the extra 5K in savings I would make a one time extra payment of 5K to my mortgage.
While it’s not a bad idea to get a home equity line of credit while you’re employed, since you can’t get one if you lose your job, I don’t think it should be used for things like cars but it could save you in an extreme emergency like job loss, emergency home repair or expensive medical care. Otherwise I don’t like to use home equity on anything not home related. Only get one if you can trust yourself to not use it casually.
Paying down the car will have a large immediate effect on your monthly cash flow - you pay that 5,000, you’ve still got 5,000 for emergencies in the bank, and you’ve freed up 350 a month.
It may be tough to get the bank to get rid of the PMI, especially the way values have dropped. I don’t know your current situation, house value, original loan amt etc. but I’d be leery of throwing the 10,000 at it even if you knew that would sufficient to get rid of the PMI - as you said, it’s only a 50 a month difference, and it leaves you with a car payment, a mortgage payment, and no liquid savings.
While I’m a big proponent of paying extra on the mortgage, throwing a huge chunk of cash at it and leaving yourself with reserves is risky. I’d personally be more comfortable with a smaller monthly prepayment (it’s what we’re doing with ours). Also, while the prepayment reduces your long-term costs significantly, there’s no immediate improvement in the cash flow.
Whatever you are paying monthly for PMI brings you no benefit whatsoever - you are buying insurance for your mortgage-holder. While agreeing with other posters as to priority of emergency funds & retirement, if I had any extra money I would be paying down principal with an aim of getting rid of PMI as soon as possible.
Assuming you have $10,000 above and beyond emergency and other savings, otherwise, you should probably work on that.
But I don’t understand this:
PMI is usually required if the homeowner doesn’t have enough equity (usually 20%) in the house. And, typically, once the owner pays off enough of the mortgage to get 20% equity, PMI can be dropped.
So I’m assuming that ‘using $10,000 to pay down the PMI’ means ‘immediately paying an extra $10,000 on the mortgage, which will allow me to drop PMI’.
In that case, right away you’re saving $50/month, or $600/year, which means you’re getting 6% return on that investment, BUT you’re also paying less mortgage interest – the amount you would be paying for that $10,000 in principal. That’s another 4% (actually more like 3% after tax benefits) you’re getting on that $10,000.
So, essentially, putting that $10,000 to the mortgage principle gets you like 9% a year. If the car loan is more than 9%, pay that off first, but otherwise I fail to see how this isn’t a big winner. PMI is just wasted money; get rid of it if you can.
Paying extra on your mortgage doesn’t change the terms of your mortgage. As you state the hypothetical is a 30 year fixed. By paying extra you would not see any advantage in the near term - you would only see advantage on the back end. You would pay the mortgage off sooner, but it would still be years away. If your concern is near term - your current monthly budget - then paying extra on the mortgage is not helping.
Regarding the strategy of paying the mortgage down in order to retire the PMI - look at how much you would be paying out vs. how much you would save over time. It could be better just to keep the ~$50 PMI cost flattened out over time.
So, all that said - it is unclear what your actual goals are beyond “saving money”. Is it building up cash savings, or reducing monthly payments, or reducing overall cost over time, etc.? Could be all three - but in what priority?
A better understanding of your goals would help in making recommendations.
