Loan Strategy

My first priority is paying off our credit card debt. It's the biggest monthly burden, drags down our credit scores, is viewed negatively by insurance companies and lenders, and causes the most angst (especially when the credit card companies change the repayment terms by adjusting interest rates and hiking minimum payments!).

But when the credit cards are gone, we'll have to decide what to tackle next. Aside from car loans, the major debts would be student loans and the mortgages. We have two student loans, each with about $25k owed, our second mortgage at around $27k, and our first mortgage at approximately $138k. I'm not going to even think twice about the primary mortgage, but the other three are all on my list of things to pay off quickly and ahead of schedule.

The student loans are on a 20-year repayment plan, with nearly 16 years left. The interest rates are pretty low, around 3.5% (fixed). They're through the federal government, and Hubby & I each have our own. If we are tight on money, we can easily put either or both into hardship deferral without any negative consequences. Student loan interest is tax-deductible for both state and federal income taxes. And if one of us dies, that person's loan is forgiven - I wouldn't be stuck paying off his, or vice versa. The down side is that if we were ever to declare bankruptcy, the student loans cannot be discharged.

The second mortgage is a 15-year balloon at just under 10% (fixed). We have 11.5 years left of payments, at which point we'd either have to pay a lump-sum (I think of approximately $20k), or we'd have to refinance and roll in the remainder. The mortgage interest we pay is tax deductible for federal income tax, but only if we itemize (which is highly likely for at least the next 5 years, and quite possibly longer). We would be able to eliminate this debt if we declare bankruptcy or gave the house back to the bank, and could get away paying pennies on the dollar if we did a short-sale.

Although this is one of those situations where Dave Ramsey recommends paying the student loans first, because the outstanding balance on each loan is smaller, I really can't convince myself of the wisdom in that. Pretty much every way I see it, paying off the second mortgage before the student loans makes infinitely more sense.

Baby Step #2

I don't adhere to the Dave Ramsey plan, as I've mentioned before. I'm too much of a numbers girl, and the thought of paying off smaller debts without taking into consideration interest rates just bothers me too much. For many of the credit card debts, the lowest balances were the highest interest rates (due to several sizable balance transfers with low fixed rate offers). I understand his rationale, that it's more a psychological thing, and that if you're paying off debt quickly the difference in interest is nominal... but if you have a lot of debt, even a nominal difference in interest can make a big difference. 

So far I've really only focused on paying off credit card debt. In July 2008, we hit our highest outstanding balance - a total of $48,749.15.   Today, a little over a year later, we're down to owing $22,926.12.

But Dave Ramsey's Baby Steps program calls for paying off more than just credit cards. He recommends in Baby Step #2, which comes after building a small $1000 emergency fund, listing and paying off debts smallest to largest (except for the mortgage). While I'm not following this plan, I'd ultimately like to get to the same end point and be debt-free. Here's what we would have to pay to get there: 

1. Student Loan #1: $   1,101
2. Student Loan #2: $  1,328
3. Car Loan #1:  $  6,054
   
4. Credit Card #1: $  6,500
5. Car Loan #2:  $10,852
   
6. Credit Card #2:   $16,288
7. Student Loan #4: $24,548
8. Student Loan #3: $24,587
   
9. 2nd Mortgage:  $26,428  (DR says to include it if it's less than 1/2 your annual income)

TOTAL, not counting 1st Mortgage:  $117,686

That's a big number, and makes the amount we've paid off so far seem so measly. I guess, to be fair, we've also paid off quite a bit on each of those other items that isn't included in the total (on the two vehicles we're paying off about $8500/yr in principal, and we're paying about $3000/year in principal on the student loans). 

Save Up or Pay Down?

I listen to Dave Ramsey and Suze Orman, but I don't necessarily agree with everything they say.

Dave Ramsey recommends creating a $1000 baby emergency fund, and then paying off debts smallest to largest (based on amount owed). Suze Orman recommends paying off debts in the order of highest interest rate, regardless of principal balance. She used to say to focus on paying down debts aggressively, then to save up an emergency fund after the debts are paid off - but she has changed her advice and now recommends only paying the minimum on credit cards and saving the rest for emergencies (until you have 8 months worth of living expenses saved up).

Intellectually, I have a really hard time with Dave Ramsey's advice. If I have one credit card with a 20% interest rate, and another with a fixed 6% interest rate, I'm going to pay a lot more in interest by paying off the 6% card first. I know that he says you'll pay it off quickly enough that it won't matter, but the reality is that it does add up - especially if the balance owed is very high, to the point that it would take a year or two (or more!) to pay it in full. I get his point, that it's a psychological feel-good thing, but I can't bring myself to follow his advice. The other problem is that $1000 for an emergency fund doesn't get very far - we've had a few major home repairs that have cost far more than that, and were things that were truly urgent and necessary (heat & plumbing).

But I don't like Suze's advice either. Eight months of living expenses is a LOT of money, even for someone sitting in a very secure financial situation. With absolutely no consumer debt, and a paid-off mortgage, that would still take at least a few months to save up that much money. And for someone who owes a lot of money, it would take a couple of years (or more!) to save that much up, meanwhile you'd be paying a ton in interest.

I'll admit that the credit crunch and recession has made me a little gun-shy, and I did shift my focus from aggressive debt payoff to a blend of debt payoff & saving. I had been paying off about $1000/mo on one of the credit cards, and practically nothing into an emergency fund, but when the credit companies started slashing credit limits and chasing balances, I decided to put $500/mo towards the card and another $500/mo in a savings account.

I've got $5000 saved in my emergency fund, enough to make me feel comfortable. I just don't know whether I should continue my 50/50 strategy, or if I should hold the emergency fund at $5000 and refocus on paying down the credit card debts.

Any advice?