I Have Two Loans. Which Should I Pay First?

Dear Kristin,

I purchased a home for $204,000 in 2016 with a 30 year mortgage. The mortgage was split into two loans, $182,000 at 3.5% and $22,000 at 5.50 %. The interest rates are fixed. The payment for the main loan is $992 a month and the second $126 a month. The escrow is taken out from the main loan. I plan to retire in three years. Are there any advantages of paying off the small loan, in three years, or would it be financially better to apply that to the principal on the main loan? What advantages are there short term and long term?

Sincerely, 

Johan

Dear Johan,

You’ve asked a few questions here, one of them being which loan you should try to speed up payments on: your larger, main loan, or your smaller loan with lower payments. Generally speaking, you’ll save more money by tackling the debt with the higher interest rate. In this case, that would be your smaller loan, which has a significantly higher interest rate. 

What’s the advantage? Money saved! Banks make money by charging you interest on the money you borrow, and over the life of the loan the bank can make thousands or hundreds of thousands of dollars (as is often the case with mortgages). By paying off a loan faster, you reduce how much you’ll end up paying in interest payments. 

But considering the big difference in the size of the two loans, you’ll still end up paying quite a bit in interest on the main loan. So consider if you can do both.

In order to pay off your small loan in three years, you’ll have to increase your monthly mortgage payments to around $626 from the $126 you said you currently pay. That might not leave you with a lot of money left over to speed up payments on your main loan, but if you can do it I would suggest doing so. That way you’ll save money in the long run on both loans. But just by paying off the smaller loan in three years, you’ll save about $14,350 in interest you would have paid over the next 24 years. (I used a mortgage calculator to check the math, and you can too, to test various repayment scenarios.) 

What’s more, when you pay off the small loan you can then accelerate paying off the larger loan by redirecting the extra funds you had allocated for the smaller loan. If you follow that plan and pay an additional $500 per month, you’ll pay off the larger loan almost 10 years early, and save $29,779 or so in interest. And if you have any extra funds in your escrow account when you finish paying off that loan, you’ll be entitled to a refund. 

The main caveat to all this is that many states allow you to be penalized for paying off your loan early, so make sure you can speed up the payments and pay the loans off early without getting dinged. Make sure to check the terms of your loan to see if your mortgage has such a clause buried in the language. That said, depending on the penalty, you might find that the money you save from paying off your loan early is more than the fine, so be sure to crunch the numbers to determine which is better for you. 

-Kristin

If you have questions about money, Kristin is here to help. Submit an anonymous question and she may answer it in a future column.