Reader mailbag: Should I pay off debt with the highest interest rate first?

I am a big fan of three sports: basketball, baseball, and golf. The next week and a half is perhaps the most exciting period of the year for someone who is a fan of those three sports. The Masters. The men’s and women’s Final Four. The opening of the baseball season.

Why do I like sports? I like watching competition. I know the incredible amount of hard work that goes on when we’re not watching that makes it possible for those people to perform on the screen. I like the strategic choices of it.

And every once in a while, all of that clicks together into something sublime.

Do interest rates fluctuate over time, or do you get locked in to a certain rate at the time you sign up?
- Jamison

Bank interest rates definitely fluctuate over time, at least with online banks. Some banks – usually large brick and mortar ones – do maintain the same rates over many years, and it’s usually a low one. Smaller banks and online banks tend to vary their interest rates more.

How do they vary it? It varies based on what the Federal Reserve does with the prime lending rate (going up when the Fed raises rates and so on). It varies based on the marketing goals of the bank. It varies based on what the competitors are doing.

If you sign up for an account at an online bank, don’t be surprised to see the rate you earn vary over time. Right now, I would say that rates are definitely at the low end of the spectrum, but the Federal Reserve rates are also very low, too.

I have a private student loan at 6.54% (154/mo) and a car payment at 3.9% (493/mo). The car will be paid off in 30 months and both loans currently have a balance of 13k each. Also, I do not receive any tax benefits from either debt.

I am in the process of saving up for a home/condo but NJ is still very expensive and with the excess of shadow inventory I don’t think its quite the time to buy yet. My DTI is only 12% and I only have about 25k in non-retirement liquid investments saved up. Ideally I would need 25-50k minimum saved for a 10-20% down payment. So I’m currently debating hoarding cash or paying off at least one of these loans ASAP.

I’m a math/stats guy so paying off the student loan at the higher rate first would be my best instinct. However, would it make sense to pay off the car loan first, even though its a fairly cheap interest rate, to free up more cash flow on a short-term monthly basis (with sights on real estate purchase from 6-18 months away)?
- Bryan

What you’re essentially doing here is comparing the Dave Ramsey snowball debt repayment method against the “maximize every cent” repayment method. If you pay off the smaller loan first in order to improve your cash flow, you’re basically using Dave’s method.

I think your plan makes reasonable sense – paying off the car loan first because the monthly payments are higher. If I were you, I’d throw every dollar towards that car loan and get it out of the way, then re-evaluate where you’re at with your money and where you want to go next. If you still feel like the housing purchase is a long way off, then pay off the student loan.

I wouldn’t worry too much about “shadow inventory” and timing the purchase perfectly. The market isn’t going to suddenly overheat again. Buy when you’re ready with a down payment – you’ll save far more money by doing that than you would by timing the buy perfectly.

I have a car loan with a balance right at $15K @ 5.49%. If I were to pay it off with the normal amortization it will be repaid around January of 2013.

I also have about $22K in liquid savings, along with another $12K in stock that I could sell at any time. My monthly living expenses are only about $3000 to $3500 (probably at the lower end if I were to lose my job as I could cut back on some things), meaning my emergency fund is about 7.33 months assuming just my savings, and about 11.33 months if you count the stock I could sell.

My question is this: should I go ahead and pay off the car loan with money from savings and take advantage of the roughly 4% spread between my savings account and car loan (and the benefit of less debt and increased cash flow)? Emergency fund would go to 2.33 months with just savings, and 6.33 months if I include stock. However, I would be able to build this back up pretty aggressively with the car payment going away.

More on my story: I am single, no kids, stable well-paying job. No big purchases coming in the near term. If I no longer had a car payment I could stash away about $1,000 a month into my savings account to build my emergency fund back up. And yes, I’m contributing to my 401K (about 16% of my salary when you include my employer match). My only other debt is a mortgage with a balance of $165K @ 5.25% and a student loan with a balance of about $21K @ 2.1%.
- Nick

If you’re single with no kids, I would absolutely go ahead and pay off that debt. Dropping your emergency fund to “only” two and a half months’ worth of living expenses isn’t a deep concern in your position, particularly if you have other assets you can tap beyond that if you absolutely must.

Larger emergency funds are more important for people who have dependents – spouses and children. The more people that are represented on your tax return, the larger your emergency fund ought to be.

For single people, a two month emergency fund is just fine, though it doesn’t hurt to have a larger one.

At what point in the Dave Ramsey baby steps should I begin saving for a house? His advice seems to assume that I am already stuck in mortgage debt and discusses when to finish paying it off, but when should I actually purchase it if I am currently debt free?
- Kevin

Dave’s advice makes several assumptions about people’s lives, but it’s still sound advice in the end. You just have to do a bit of interpretation.

From the way I read it, saving for a down payment is part of the sixth baby step. In other words, you should get debt free, build an emergency fund, start saving for retirement, and start saving for college if you have kids before you start saving for a down payment.

From my perspective, I think his advice makes sense. However, I also understand why people are very anxious to own a home of their own. My advice? Be intense. Don’t let up when you manage to pay off your debts. Use every tactic you can to cover all of your goals. Think big (your home), not small (that treat on your way to work).

I’m 26 years old and in a high-paying field – my salary is $145K a year. I’ve only been at it for 2 months, though, and I don’t much like the job. Turns out I value my free time more than I value making money (as I suspected I would), and I’m sacrificing a lot of the former for the latter. As it stands, I’ve saved about $2,000 and put another $1,500 in my 401K, but I’ve got $160,000 in student loan debt ($130K at 7.6% interest, the rest at 4%). I don’t have any credit card debt, live pretty cheaply and could and would cut more.

My goal now is to move to another city with a much cheaper cost of living and buy a small house. Aside from that goal (and buying a dog), I don’t have any others. I don’t know what kind of work I want to do or anything like that. I just know I want more time.

My plan right now is to build up an emergency fund, try to save up a down payment for the house, and then make the move. I’m willing to be saddled with the debt for the next 30 years if that’s the price of freedom. I’m writing to you to try to put some solid figures on everything; how much do you think I should shoot for in savings? That question will determine how long I stay at my current job. I know I’ll have to get another job, but I don’t think I’ll ever make as much as I do now again. My hope is that I never have to work for someone else as much again either.
- Mike

My first question is whether or not you’re going to try to get a job in the same field as your current job. Are you going to continue your career or not?

If you are going to continue your career, then I would start job hunting immediately and move quickly. If you’re not going to continue your career, I’d stick around as long as I could possibly stand it, because that’s very good money and you’ll need a financial foundation to make a career leap.

If I were you, I’d pick a very clear “end date” and focus on it. Until then, cut all of your spending to the bone. Build a nice, healthy emergency fund, then throw as much as you can at your student loan debt (the higher interest portion). If you possibly can, get debt free before you leap, because those loans will seriously hamper your cash flow and restrict what job you can afford to get when you make your leap.

Good luck!

I am writing just to ask for your personal advice on what to do with approximately $10,000 (I received from the trust). I have absolutely no background in finances or any real understanding of it, except that I know I shouldn’t just let it sit there. When I look on my bank’s website, there are so many different options that I do not even know where to begin and I am left just waiting. Do you have any suggestions of where to start looking so that it is not so overwhelming?
- Joelle

There are really two things you need to ask yourself. First, what do you want to do with this money and when do you want to do it? Do you have any goal for this money? Will it be a home down payment in five years? Will you want it for a trip in three months? Will you want it as the foundation for a business you want to open twenty years down the road? Figure out a time frame and a goal for it.

Second, can you tolerate losing money in your investments? Some people can and some people can’t. If you think to yourself, “Sure, I can tolerate risk,” but then you get scared when you’ve lost 40% of your investment, you’re going to make the worst possible move you could with your money. If you can’t imagine being able to stand it after losing 40% of the money, then you should be in something safe and conservative that doesn’t earn a large return.

If you have a long term goal and don’t mind the risk, I would put all of it in Vanguard in their total stock market index fund. If you do this, just let the money stay there until you start to get close to your goals (in terms of time). If you have a long term goal and can’t stand risk, put it in a certificate of deposit at your bank. If you have a short term goal, keep it in cash (or in a very short term certificate of deposit).

What would be some safe(ish) ways to get my hard-earned money to do some legwork in this shaky economy?
- Adam

You should essentially re-read the answer to the previous question, because the same ideas apply.

Unless you’re incredibly rich (nine figure wealth or so), investing is about goals. What do you want to do with that money? When do you want to do it? Also, what is your risk tolerance?

Simply investing for the sake of investing usually leads to suboptimal results when you actually need the money. Think about your goals up front and they’ll practically tell you how to invest.

I wanted to know your opinion on cash vs. check card. In my case, I hardly ever carry cash. I used my Citibank check card mainly for 2 reasons: 1) I can more easily track my expenses using Mint.com; 2)I earn an American Airlines mile for every dollar spent (My wife and I have gone to Jamaica and St. Martin for “free” using our accumulated miles). What are your thoughts on this? Are you a cash carrier? Do you feel that using plastic makes you lose sight of the fact that you are spending money? I feel like I’m getting a better bang for my buck by using my card. Curious to know how you feel about this.
- Tony

I use plastic. I think that using plastic can result in losing touch with the idea that you’re actually spending money – unless you’re mindful of it.

For me, I’ve learned that any time I go to purchase something – no matter how I purchase it – I’m deducting from the future that I want. I keep that thought as front and center in my mind as I possibly can.

The end result is that the “trigger” for making me think about my spending isn’t pulling out cash. It’s simply approaching the “Buy Now” button or the checkout line. Every time I do either thing now, I think about what I’m doing and, sometimes, I talk myself right out of it.

We bought a house about 3 years ago, and looking back we were young and stupid and really had no business buying the house we did. But I cant change that now. We are basically able to make our payments every month, pay all the bills, and have a decent life, but at the end of the month, there is very little or none to put towards long term savings. We currently owe $290k on a house that is probably worth closer to $240k at this point in time. This is split up in a mortgage and a HELOC that we used to do 100% financing, which was yet another bad idea now that I look back. Both are with Bank of America. Neither of us can afford to stay there without both your incomes, but with our situation, staying really isnt an option.

The way I see it, there are a few possibilities. We cant just sell as we dont have the cash to make up the difference in what we owe vs what we can sell for.
Option 1 is a short sale, which I am told by a realator is doable, but Bank of America tends to be hard to work with on these, and could take up to 6 months.
Option 2 is to just walk away and let the bank forclose, hope for the best. We do live in Illinois, which is a recourse state, so they could come after us for the difference down the line.

Option 3 would be a deed in lieu of forclosure, which if my understanding is right, means the bank forcloses, but I would not be on the hook for the difference in what they sell for and what I owed. Is that correct?

Someone did suggest that we stick it out as roommates, but thats not going to happen. I am at a point where I just want out of the house and not owe anyone any money when its all said and done. I am not overly concerned about my credit rating right now, I really just need to get out of the house so I can move on with my life. She feels the same way.

Other than the house, we dont have much debt. Cars are paid for, no credit card balances, my wife has some student loans, but her parents pay those.
We maxed ourselves out on the house, so there is no retirment funds that we could draw from if we had to.

We are both likely to be living back with our parents, at least temporarily until we figure out new living accommodations.

So, any advice? is there an option I am missing here?
Looking for the quickest and cheapest way to get out of the house. Even if i could get the bank to modify and lower payments, I dont really want to stay in the house, its to far from my family/friends. Same with her.
- Jeff

The general advice of sticking with it is a good one and that’s probably what I’d recommend, but it sounds as though there are personal reasons why it’s untenable.

In that case, I’d look seriously at option #3. You have to talk to your bank about this, because it’s functionally very similar to foreclosure except you don’t get the negative credit bump out of it. It allows you to walk away scot free, almost as if you had just been renting the house for a while.

If you live in a recourse state, I wouldn’t walk away. You’ll end up being chased by them for years as they try to get their money back.

It is easy over time to have time wasters creep back into your life (perhaps TV and WoW for you) and an article like this helps to refocus our energies.

I haven’t played board games in a number of years but your bi-monthly get-togethers sound like a great idea. Any recommendations for board games or perhaps you could include them on another blog?
- Jason

My favorite game to play with people who don’t play board games much at all (aside from memories of childhood) is Ticket to Ride. It’s elegantly simple, yet can be as strategically deep as people want it to be. The pieces and graphics are beautiful, too, and it’s really flavorful, capturing a sense of riding the rails very well.

If you prefer trivia games, the best one I’ve found is Wits and Wagers, which basically combines the better elements of Trivial Pursuit with some wagering and a limited timeframe on the game (so it doesn’t go on forever).

Four other games that would fit if the above two don’t trip your trigger: Dominion, Pandemic, Carcassonne, and Modern Art.

Got any questions? Email them to me or leave them in the comments and I’ll attempt to answer them in a future mailbag. However, I do receive hundreds of questions per week, so I may not necessarily be able to answer yours.

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