Dear Dr. Don,
Let’s say I have a car loan at 4.9 percent interest and still owe $10,000 on the car. I also have a 15-year mortgage with a $65,000 principal balance at 5.125 percent.
What would be the better option to put the money toward? If I had $5,000 to put down toward one loan, which loan should I choose to save me more in the long term?
It’s an interesting question. Assuming you can use the mortgage-interest deduction on your income taxes, the home loan has a lower after-tax cost than the car loan. Conventional wisdom would have you pay down the higher-cost car loan.
Paying down the car loan, however, only saves on your interest expense for the remaining life of the car loan, while paying down the mortgage saves interest expense for a longer time period.
You weren’t specific about the remaining term of the car loan or mortgage, but you can use the amortization tables provided with Bankrate’s
Mortgage payment calculator and
Monthly auto loan payment calculator to compare the interest savings.
Both calculators allow you to input additional principal payments and they will show the reduction in loan term and total interest expense. I’ve put together a hypothetical example in the table below.
|Which loan should you prepay?|
The interest savings (pretax) line in the table doesn’t consider the tax effect of lost mortgage interest deduction when you pay down the mortgage. It’s not inconsequential. A decent estimate is to say that it’s one-third of the interest savings on the mortgage.
That makes the after-tax interest savings from prepaying $5,000 on the mortgage about equal to $3,500 — still significantly more than the $562 in interest savings from just paying down the car loan.
Like most things in life, it’s just not this clear-cut. If you chose to make an additional principal payment on the car loan, you’d be out of the loan (in my scenario) in 18 months.
What you choose to do with the amount of money equal to the car loan payment over the remaining 18 months of the original loan term is important to the analysis.
Apply that money toward the mortgage and you’d save about the same as deciding just to pay down the mortgage. That’s shown in the last column of the table.
There’s no easy way to replicate what I’ve presented in the last column, but comparing the interest savings on the car loan and the home loan is easy to do.
If you want a better estimate on the after-tax interest savings when prepaying your mortgage, use
Bankrate’s Mortgage tax deduction calculator to solve for the APR after-tax, then use that rate as the interest rate in the
Bankrate Mortgage payment calculator.
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