Paying off short term loans versus reducing mortgage, why?

I've noticed that posters are regularly advised on the forum to pay off smaller loans/credit cards etc before paying lump sum off their mortgages and I'm trying to figure this out.

I have a lump sum of 30k which I'm considering putting towards my 400k odd mortgage, yet I also have a car loan at approx the same amount (30k). There is only four years left on my car loan yet there are 30 left on my mortgage, so taking compound interest into account, surely it is more advisable to reduce the mortgage by 30k rather than clear the car loan?

Have been using cost of credit calculators which tell me that my car loan cost of credit is 5k approx, but cannot find anything which tells me the savings on paying off 30k off my mortgage.

Anyone have any advice on the calculations?

Many thanks

Simply, the interest rate is higher, so you're paying more money for nothing.

If you pay off the car loan, and then use what you were paying on the car to make an additional payment into your mortgage every month for what would be the remaining term of the car loan, you'll end up better off.

marshmallow said:

Anyone have any advice on the calculations?

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Yes - use Karl Jeacle's mortgage calculator to estimate the potential savings of accelerating repayment or a mortgage or any other loan. Factor in any other tax relief, charges/penalties etc. that might apply. Normally it makes sense to pay off unsecured, high rate debt before other debts (e.g. mortgage - which is normally the lowest cost form of debt and also qualifies for some tax relief) but ultimately you need to crunch the numbers to see what's most appropriate for your specific personal circumstances.

Yes, but I am only paying the car loan for 5 years versus 30 years on the mortgage, so even taking into account the lower interest rate, with compound interest the mortgage ends up costing way more?

Did you try crunching the numbers as I suggested?

marshmallow said:

Yes, but I am only paying the car loan for 5 years versus 30 years on the mortgage, so even taking into account the lower interest rate, with compound interest the mortgage ends up costing way more?

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That train of thought effectively ignores the opportunity cost of the additional interest payments on the car loan over the 30 years on the mortgage. It's a bit like saying that you'd rather take say €12,000 in 30 years than €10,000 now and justifying it by saying you'll have more money at the end of the day. Not true.

OK, using the jeacle calculator, 30k over 30 years at a rate of 4.84 will cost me 26,923 in interest! Whereas 30k over 5 years at a rate of 6.9 will cost me 5,557 in interest. So unless I'm completely missing something, I can't understand how paying off the car over the mortgage makes any sense at all?

What about what Trent said above?

Are you planning to still own the house in 30 years or will you be selling it before then? If you plan to sell in 5 or 10 years for instance (and therefore at that point pay off the mortgage) would it not be more accurate to crunch the mortgage interest figures according to this time frame?

This is quite a simple idea.

If your alternative courses of action are merely either paying off the short term (high interest rate) loan or paying an equal amount off the long term (low interest) debt, you'd be better off doing the latter. You'd save more interest.

But that's not what you should do.

You should pay off the short term debt and then use the money you would have been paying off that debt on an ongoing basis to make extra (pre-) payments on the long term debt to clear it early to save the interest on it.

That's the logic behind the consensus that higher interest (short term) loans should be targeted for early redemption.

It would, of course, be a mug's game to use your lump sum to pay off your car loan and then simply increase your discretionary expenditure by the monthly amount of those current repayments. You would effectively be borrowing over the lifetime of your mortgage for an asset (the car) which will be wasted long before the mortgage is redeemed.

ClubMan said:

What about what Trent said above?

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Can't really get my head around that either! Would it make more sense if I divide the cost of credit by the no of years?

I think Oysterman's post says it all and reiterates the point that Trent made.

Sprite

If you use the Extra Payments button on the Jeacle calculator you can specify a start and end month for your payments so set these to the same as the car loan term remaining.

So you are comparing making one lump sum repayment of 30000 versus 48 payments equal to the amount of your current car loan payment.

Of course add in the interest saved on the car loan as well at the end.

Imagine you currently have €370k loan at a low mortgage rate (say 5%), a second €30k loan at the same mortgage rate (totalling €400k in mortgage) and €30k loan at a higher car loan rate (say 10%). You can pay off one or other of the €30k loans, one of which costs you (in very simple terms) €1500/year in interest (the mortgage) and the other costs €3,000/year (the car loan). The fact that the €370k loan is still costing lots in interest doesn't effect the decision on which of the €30k loans to pay off.

You pretty much always pay the higher interest loans first - the most expensive debts.

The number of years left on each isn't as relevant as it might appear.

Remember a 30 year mortgage is only that in name, there's nothing to stop you paying off a non-fixed rate mortgage off earlier if you wish to and are able to. So that would render any calculations of interest based on 30 years invalid.

Chances are if you can rid of all your other more expensive debts you'll be able to use the savings made from that to knock years off the mortgage.

Thanks for your help, think I've got it straight in my head now, will be paying off the car loan.