Pay Off Home Loan or Car Loan?

April 10, 2000 " I am currently sending $300 a month in additional principal on my 30-year, 7-percent mortgage to pay off the loan in approximately 15 years. Would it be wiser to make this extra payment on my 8.49 percent car loan? Are additional principal payments treated the same way for home mortgages and car loans?" If the interest rates were the same, you would do a little better paying off the mortgage loan before the car loan. On all mortgages, except "simple interest" mortgages, additional principal payments reduce the balance at the end of the preceding month by the same amount. For example, if your March 31 balance is $100,000 and you pay an additional $100 on the 15th of April, the balance on April 30 would be $99,900. Since the interest due on May 1 for the month of April would be calculated on $99,900, you save the interest on $100 for the first 15 days of April. Car loans, in contrast, accrue interest daily. On a car loan, the additional $100 payment would be deducted from the balance on April 15, rather than the balance at the end of March. You don't get free use of the $100 for 15 days. But the difference does not add up to much. Suppose you have a $100,000 loan at 8.50% loan for 30 years and you systematically make an extra principal payment of $64 on the 15th day of every month. If the extra payment is credited back to the end of the preceding month, as on a mortgage, it will pay off the loan only 3 weeks earlier than if the interest accrues to the 15th, as on a car loan. The effective interest cost in the second case will be .014% higher, or 8.514% instead of 8.500%. In your case, the rate on the car loan is so much higher than the rate on the mortgage that it swamps the effect of interest accrual during the month. Pay off the car loan first. Copyright Jack Guttentag 2002

Jack Guttentag is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Visit the Mortgage Professor's web site for more answers to commonly asked questions.

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