The Best Method for Paying Off Each Kind of Loan
By Geoff Williams | July 6, 2016
One size does not fit all. You shouldn't employ the same strategy for paying off your mortgage, credit cards and car loan.
If you sometimes daydream about being thrown into an old-fashioned debtor's prison, small wonder. According to a recent analysis by the research company Gallup, which based its information on data collected by the Federal Reserve, the average household has $7,828 in revolving credit card debt. Meanwhile, Americans are also juggling mortgages, auto loans, student debt and personal loans. In fact, earlier this year, the U.S. Department of Education released a report noting that more than 40 percent of Americans with federal student loans are behind on payments.
So what's the best method for paying off each kind of loan? Experts recommend the following approaches.
If you're paying your mortgage off slowly, month by month, so that one day, far off in the future, it'll be paid off, you're doing it right, according to most experts. That's for a variety of reasons, from being able to get a significant tax deduction to the simple fact that you could be using the cash that's going to your home loan (which hopefully has a low interest rate) on just about anything else, from retirement to college savings for your kid.
But if you want to pay it off faster than the standard 30-year period, then "the best way to pay off your mortgage is to consistently make extra principal payments every month," says Sandy Young, founder of the SY Financial Group in Hampstead, Maryland.
"Run an amortization schedule and follow it," she suggests. "Making your monthly payment into bi-weekly could also be an advantage. This would be equivalent to one extra monthly payment each year."
But, again, the question you should ask yourself is: Can you afford to do that? If you have a loan that's going to be paid off in 30 years, and you pay extra so you can finish in 26 (and for those 26 years, money feels tight) will it be worth it?
"Another question to ask is whether or not there are other debts, such as student loans or credit cards, that you wish to pay down to help improve your credit and lower your interest-payment obligations," says Sean Stein Smith, a certified public accountant in New York City.
But for most people – slow and steady wins the race.
Your Car Loan
Same deal, most experts say. However, because a car loan is usually far less than a home loan, it can make more sense to pay this off faster.
Here, too, making bi-monthly payments can also be wise, Smith says.
It sounds goofy at first, but if you do the math, that's 26 payments a year, instead of 12 a year. If your car payment is $100 a month (just to make the math easy), you'd be paying $1,200 a year if you paid off your car via the conventional 12 monthly payments. If you make 26 payments of $50 each, however, over the course of a year, you've paid your auto lender $1,300.
"Very importantly, by reducing your debt faster you will also reduce the overall interest you will be paying. Remember that every dollar in interest you pay does nothing to reduce your overall debt," Smith says.
But talk to your lender, which may or may not allow this payment structure or may ding you with penalties if you pay off the loan early.
In this case, you definitely should pay off as much of the debt as possible, as fast as you can. Revolving debt – that is, credit card debt you carry from month to month – is a money killer, thanks to compounding interest that just grows and grows.
If you have a collection of credit cards with revolving debt and are trying to figure out how to whittle it down, try these suggestions from Katie Ross, education and development manager at American Consumer Credit Counseling, headquartered in Newtown, Massachusetts:
If you have multiple debts, pay the one with the high interest rate first. "This will reduce the amount you pay over the long term," she says.
That said, many experts recommend using the snowball debt method, which describes paying the credit card debt with the lowest balance first, then taking the money you save and putting it toward the next credit card with the lowest balance. But Ross is right, if you want the best method, and if you like knowing the cutesy names for your credit card reduction strategies, many experts call paying down the debt with the highest interest rate first the avalanche debt method.
Always pay more than the minimum balance. "By paying as little as possible, you're ensuring that you remain in debt longer and likely are going to end up paying significantly more in interest in the end," Ross says.
Don't use credit cards when you have revolving debt, experts say. "If you're in debt already, stop using credit to pay for things," Ross says.
Your Student Loans
It's generally pretty straightforward: Make your payments on time, and if you're able, says Coleen Pantalone, a finance professor at the D'Amore McKim School of Business at Northeastern University in Boston, "commit to paying an extra $50 or $100 each month on the loan. ... That extra amount goes to reducing the balance of the loan, so your total interest expenses over the life of the loan will go down."
But equally important is ensuring you don't make mistakes in paying your student loans. For instance, Ross says one common flub is consolidating federal loans with a private lender.
"Federal student loans come with built-in benefits and protections from the federal government. If you consolidate these loans with a private lender, you are sacrificing these protections," she says.
Unfortunately, the best strategies for paying off loans are relatively boring. In fact, if somebody's convinced you of a surefire, too-good-to-be-true method of shedding your debts quickly, you're probably about to stumble into one of the worst ways to pay off a loan.