This is the third installment in Luneray‘s homebuying adventure. In the first part, she looked at houses. Last week she made an offer. In today’s third part, she discusses coming face-to-face with a lifetime of debt. (Bold emphasis added by J.D.)
This house buying experience has been a real eye-opener when it comes to finances, besides the overwhelming shock of sheer indebtedness. I’ve been trying to figure out a way to get everything paid off as soon as possible.
I’ve been reading about the debt snowball method of debt reduction. Conventional fiscal wisdom says that the smartest plan of action is to pay off the debt with the highest interest rate first. From a fiscal standpoint, that’s probably the wisest choice, because you pay the least amount of interest this way. However, humans are flighty creatures, prone to frustration and despair. If you are like me and have multiple individual debts (seven separate student loans!), and if your loan with the highest interest rate also has one of the highest balances, then it will take a long time to get that loan paid off.
The debt snowball technique is not the most prudent financially but it’s good psychologically. We humans like encouragement, and we are likely to continue the good work when we see results. With this method, you make aggressive payments to pay off the loan with the smallest balance first and make the regularly scheduled payment on all the rest. When that first loan is paid off, you take the money you paying toward that and add it to the regular payment to the next smallest loan until that’s paid off, then take those two payments and add it to the third — you get the idea.
I’ve been playing around with Excel today, trying to get an idea how quickly these loans can be paid off. Our car has the smallest balance, so if I increase our payment to $250 a month, then it will paid off by August. Oscar’s student loan repayments begin in November, so we will make regular payments until August when I’ll take that $250 and add it to loan #1. (Yes, you read that right. His repayments begin in November. And we decide to buy a house right now. Student loans and mortgage payments all begin in the same month!) With the regularly scheduled payments, all the loans will be paid off in 2026. (Twenty year repayment for most of them.) With the snowball method, loan #1 will be paid off in January 2009, loan 2 in April 2010, loan 3 in April 2011, and so forth.
I’ve also read a strategy to pay off the mortgage faster. If you get paid every two weeks, then if you pay half of your monthly mortgage payments out of each paycheck, then you can pay off your mortgage several years in advance. Seriously. However, what I’ve never heard is that if you can still knock several years off your mortgage if you pay half your regularly scheduled mortgage payment twice a month.
Consider a $150,000 mortgage, 30 year loan period, 6.25%. The monthly payment is $923.58.
With monthly payments, you will have 360 scheduled payments and you will pay $182,487.29 in interest. On that same mortgage, with 24 yearly payments (semi-monthly) instead of 12, each payment is $461.58, so you still pay the same amount each month. However, If you pay twice a month, you are paying a little more towards the loan principal each time, so you are not earning as much interest and you can still knock several years off the life of the loan without any additional out of pocket expenses. (In this case, you will pay off the loan in just 16 years instead of 30, and you pay $123,922.40 in interest.)
Assuming, of course, that your bank will let you set up semi-monthly payments.
So I wonder how quickly I can pay off the student loans using the semi-monthly strategy. Unfortunately, this will mean having to make manual payments (actually sending in a check!) instead of an automatic withdraw, plus it puts a lot of responsibility on me to actually keep up with it. It’s kind of nice having the car and visa with the credit union because I can transfer money toward the balances anytime I feel like it.
Oh damn. I just got this message from the mortgage broker:
“Regarding the bi-weekly question. Most lenders will offer that as well, also usually after the loan is closed. Here’s my take on that option, take it for what it’s worth. Most lenders will not accept a partial payment, so when they pull the first half of payment they hold it (making interest) until the second half is pulled at which point they apply it to the loan. Usually they charge to set that option up, I’ve seen as much as $500 set up fee. The true benefit is that with 52 weeks in the year and therefore 26 bi-weeklies, you are actually making 13 payments a year which will cut the payoff time down on your mortgage. I normally suggest, that if that’s your goal, if you paid basically an extra $100/month, which equates to $1200/year, you are essentially making that extra payment a year, without them making the interest off your money 1/2 of each month and your set up fee. I don’t know if that helps at all, but it’s always seemed to me that while it’s a good idea to make the extra payments, I don’t think they should make money off of you to do that.”
Buying a house — especially buying your first house — is emotionally draining. It’s scary. Thanks to Luneray for sharing her home-buying adventure with GRS readers. Please keep comments constructive.
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