dwlink

Agreed - always pay highest interest first if you disregard taxes. When you start to involve tax deductions/credits, then it might be beneficial to make additional payments on the lower interest rate loan up to the maximum interest that can be deducted if the interest on that loan is deductible - such as student loans or a mortgage if your taxable income qualifies.

Should you find yourself earning in the mid $100k's it is generally a good idea to max out your pre-tax IRA contributions to keep your taxable income low enough to get the tax deductions on interest as mentioned above.

ericsan13

Fair enough, we can agree to disagree. But if you crunch the numbers you will see that amortization schedule is extremely important if the timing between the two loans differs. Principal to EMI ratio is much more important than interest rate and is the determining factor in which loan you should add extra principal into.

If you don't believe me I would highly suggest you speak to a financial adviser or banker who can walk you though the calculations. Seriously please don't throw your money away to the bank if you find yourself in a similar situation or lead others to do so!

Best,
Eric

ericsan13

In general, yes. But always? NO!

Because you pay most interest at the beginning of the loan and barely any interest at the end of the loan, it makes most sense to put your extra principal into the loan with the highest interest to EMI.

See for yourself here: https://dl.dropboxusercontent.com/u/...tionSched.xlsx

sick21

I'd rather get a low interest loan and save the 20k..

vlad_a

Eric, I am not sure how to explain that the math is extremely simple. Principal * Interest is what bank gets. You get what is left. This is not a myth banks came up with, but a simple mathematical equation. I do not need a financial adviser to explain this. Each time period you pay interest on what you owe at that given time. That is the key - given time. Amortization schedule is a useless metric.

You will see a flaw in your logic if you apply 0% interest to a loan. By your definition, this would be the best loan to pay off first, as its EMI=0. EMI to principal ratio would be 0% and 100% of your payments will go to the principal. Do you think this is the first loan to attack? Absolutely not!

I give up.

ericsan13

Vlad, it sounds like your assumption is that if you pay extra principal, the bank takes the same amount of interest for the remainder of the loan no matter what. As interest compounds monthly, how you change your principal affects your overall interest paid. It is not a simple calculation as the amount of interest you pay in each and every payment changes with time.

There is no flaw in logic if you apply 0% interest to a loan (what a nice loan btw!). Your principal to EMI is 100% in this case, meaning that you should make the minimum payment to this loan and pay other loans. You pay the extra principal into the loan with the lowest principal to EMI first.

Take a look at the spreadsheet I posted before you give up. You will be surprised.

vlad_a

Eric, that is not the assumption. Each time period, the EMI is remaining principal * interest.
It is the EMI rate that has you confused. For each extra payment you make, you reduce the remaining principal by that amount.
In other words, if you make 10,000 payment, the next month you will be paying EMI on that loan for $10,000 less principal. Do you see where I am going with this? This would be $10,000 * interest for that period. The next period, the EMI less will be $10,000 * (1+interest) * interest.. The next one is $10,000 * (1+interest) * (1+interest) * interest. Are you following? The total loan amount makes absolutely no difference. This just turns out to be equivalent of borrowing $10,000 at the same rate, but making $0 payments on it. Therefore, the EMI percentage is also of no use. And the only thing affecting this amount is the interest rate. Like I said, nothing to it.

P.S.
Those are nice loans to have. There used to be more of them due to marketing strategies suited for customers that don't completely understand how interest works.

ericsan13

Correct, the interest paid each period is your Beginning Balance * Interest Rate / 12. However where you choose to put in the extra principal affects your Beginning Balance. You will lose money overtime because you failed to pay down the loan that will be compounding for much longer.

Trust me, I am far from confused. Did you take a look at the spreadsheet? I am presenting you with hard math, evidence, and the situation in which it makes more sense to pay the higher interest loan. Not sure how else to explain it to you, but I will make you a believer!

vlad_a

Eric, I think the part you are missing is, technically, each month is your new beginning balance month.
When you open a 60-month loan, next month, it will be equivalent to 59 month loan, with new beginning balance=original balance*(1+Interest/12)-payment. This is now your new beginning balance. And the next one, will be 58-month loan, which equals 59 month balance*(1+Interest/12)-payment.

ericsan13

No, I am not missing that part. If you consider what you just said against our two loans, for the 3% loan you have 60 payments remaining. For the 5% loan you have 11 payments remaining. It makes sense to pay down the principal for the 3% loan because it will be compounding over 60 months as opposed to the 5% loan which only has 11 payments left to compound.

If you did check out the spreadsheet and still do not understand the mathematical proof, then please let me know and I will try my best to explain more clearly for you.

https://dl.dropboxusercontent.com/u/...tionSched.xlsx

vlad_a

Eric, you don't understand the compounding part. The loan will compound starting from right now until it is paid off. It can be paid off at ANY time. The amortization schedule is simply a guide. I can turn a 60 month loan into an 11 month loan by simply increasing payments. How are them, apples?

For both loans above, in one month, I will pay 3% / 12 and 5% / 12 EMI respectably. That is it. Their term and amount make absolutely no difference. That is the math. If I reduce any one of them by $10,000, in one month I will save 3% / 12 * $10,000 = $25 or 5% / 12 * $10,000 = $42.
It is that simple. Add the compounding part, and that number only increases progressively.

Just imagine dealing with an equity line of credit that has no defined term. How long will that have to compound. Never mind floating interest rate.

kitlz

I'm sure Christy26 appreciates all the input but this thread is getting a bit out of control. Let's agree to disagree. If you must continue, take it to PM. Thanks.

vlad_a

Thanks, Anita! Feel free to remove any unnecessary content.

ericsan13

Thanks Anita, sounds good - we actually agreed to disagree quite a while ago =P.

Anyway I think it's better to leave the posts up and let the readers decide which scenario they believe in. It's for the benefit of the community after all, and as I continue to advise, speak to a certified financial adviser to confirm their understanding.

kitlz

I agree too, Eric. There's no reason to delete any posts. It's better to leave them so that all points of view can be considered. And everyone has been civil. It's just politicians in a debate get fewer rebuttals, LOL! Let's wait and see what Christy26 decides to do. Thanks.