It can be tough when you have multiple loans. Each month a significant portion of your paycheck is sucked away from you. This is especially difficult if you have auto and home loans, because these are likely to be two of your biggest purchases you ever make in your life — and consequently the balances and monthly payments can be huge.
Maybe you’ve decided to be proactive and pay your mortgage or auto loan back faster so you can move on with your life. If so, congratulations! Whichever loan you choose to pay down — auto or mortgage — will be a good decision.
But which one is the best decision to pay off first? Here’s a look at what you should know to make an informed conclusion.
Financial and emotional considerations
First, you need to compare the details of your two loans to see which makes more sense to pay off from a financial standpoint and an emotional standpoint.
Take a few minutes to look up the interest rates and remaining balances on both your loans. These are found on your last monthly statement, and you can always call the bank itself if you can’t find this information.
Debt snowball: Pay off the lowest balance first
It’s way easier to pay off the lowest-balance debt from an emotional standpoint. You can apply extra cash windfalls or monthly payments toward this debt and once it’s gone, you’re one step closer to ultimate debt freedom. For most people, your lowest-balance loan will probably be your car loan, unless you’re very close to paying off your mortgage.
After you pay off your first debt, you can continue applying these new payments toward your second debt until this one is fully paid off. For example, let’s say your car payment is $200 and you can afford an extra $100 toward your debt. You’d pay $300 total per month toward your car loan until that is fully paid off, and then you’d send in an extra $300 toward your mortgage until that is gone too.
Doing it this way allows you to be debt free much sooner. Heads-up, though: it also means the total monthly payment you have now — with any extra debt payments included — will remain constant until all of your loans are fully paid off. If something happens, though, you can always drop down the extra debt payments and just pay the minimums.
Debt avalanche: Pay off the highest-interest-rate debt first
From a logical standpoint, paying off the highest-interest-rate debt first makes more sense. This is because your highest-interest-rate debt costs you the most each month in terms of interest charges. If you imagine all of your debt collected into a pool (which it is, in your budget), it makes sense to get rid of the most expensive ones first.
If your mortgage has a higher interest rate, that might mean focusing your efforts on paying off this loan first, even though your auto loan usually has a smaller balance. This option may mean you won’t be paying off your auto loan early, if your mortgage balance is large.
The debt avalanche method can be tough to follow because you won’t see a “quick win” as fast as if you followed the debt snowball method and got rid of your easiest debt first. It’s actually been proved that people are more likely to follow the debt snowball method. But the math favors the debt avalanche method, if you can have the patience for that long-term approach.
What about the mortgage interest tax deduction?
One final point to consider is the mortgage interest tax deduction. You are allowed to claim a portion or the full amount of interest you pay on your mortgage as a deduction when it comes time to file your taxes, and this can be a hefty amount.
For example, let’s say your family lives in a state with no income tax and is in the 15% federal tax bracket. If you just bought a home for $190,000 at a 4.5% interest rate, you’ll get a tax deduction for $1,558 in your first year.
Interest on auto loans for personal-use cars is not tax deductible.
Should you invest your money instead?
If your mortgage interest rate is less than 7% (the average rate of return for the stock market), it can also make more sense to invest any extra money you have instead. Let’s say your mortgage interest rate is a super-low 3%. In this case, you have two choices: earn an average of 7% in the stock market, or pay 3% in interest. If you invest your money instead, you’ll likely come out ahead in the end.
Of course, you can lose money in the stock market as well, but in the long term (for example, over a 30-year mortgage) you’ll likely have more money in your pocket.
Which is the best decision for you?
Ultimately, the decision comes down to you. If you’d rather be free of debt sooner and are willing to forego a few extra bucks by doing so, pay off your smallest loan first, which is likely your auto loan.
If you’d rather have more money by the time all your debts are fully paid off, then consider paying off your highest-interest-rate debt first, or even investing the extra money instead if you can earn higher percentage returns than what you are paying in interest.
One way to make it cheaper the next time you need a loan is to get the lowest interest rates possible on your next loans. Consider comparing rates for auto loans and mortgages with SuperMoney’s tools, and learn how to get the best rates on your loans.