About 4 years ago now, a close friend of mine suffered an unfortunate injury that has changed his life significantly. Since that day and for the rest of his life, he will have to deal with this injury in one way or another barring a huge scientific breakthrough. After years of meeting with lawyers and going through dispositions and hearings, he finally got the news that he will be rewarded with a sum of money for his injury. My friend was excited to get this news and wondered what he was going to do with the settlement amount.
This situation got me thinking, if I had good sum of money coming in that was unexpected, what would I do with it??? Would I pay off some bills? Take my wife on a cruise? Donate? Invest? Or simply save until a good opportunity to invest comes up? It is easy to think of all the “fun” things that you can do with that money, but what if you wanted to do the “responsible” thing and eliminate some of your debt?
Normally if I had extra money to pay down bills with, I would choose the bill with the highest interest rate. Everyone’s financial situation is different of course, for my wife and I our situation is as follows:
- Bought a house about a year and a half ago, loan to value is currently 95% meaning we pay monthly Private Mortgage Insurance (PMI).
- I have a VERY large amount of student loans, but the interest rate is fairly low at 2.1% for undergrad and 6.5% for grad school.
- My wife leases her vehicle, while I chose to buy my car once my lease was up. The interest rate on my car loan is approximately 3.75%.
- We both invest at least 10% into our 401k accounts, and have setup mutual funds, and have a small amount invested in stocks. I think for our age we have an adequate amount saved up and a good amount invested.
Now the amount of the settlement that my friend is receiving is definitely not enough to pay off the mortgage, but it is enough to pay off both the student loans and the car. My student loans have always been a burden on my mind due to their size and they never seem to shrink no matter how much extra I try and pay into them each month. I thought about how great it would be to pay off the loan completely, how it would free my credit up and eliminate one monthly payment. Then I thought how nice it would be to pay off my car loan, since my car is 4 years old and will never stop depreciating in value, paying it off will also eliminate one monthly payment, and I can use the amount we save to pay more down towards the student loans or home mortgage.
Finally I thought about my mortgage, my 30 year fixed rate mortgage. My wife and I bought a house bigger than we need because we never want to move, we want this home to be ours until we have kids and they move away to school, then maybe sell and get a small condo to spend out our “golden years” in. I recently spoke to our mortgage company and I was told that based on the market around my property, we could refinance our house to lower our rate by 0.5%, and be able to eliminate PMI for about $10,000 down. I was told that the closing fees estimated to be about $2,000 are a part of that $10,000 amount. The amount of PMI that we pay is about $100 a month. Of course it was silly of me to think things through this thoroughly since I was not the one receiving this settlement, but it really got me wondering, what would I pay first?
Paying $10,000 on the mortgage would reduce my monthly bill by approximately $150 per month ($100 for PMI plus another 50 since my rate and loan amount are being lowered), and since we have only been paying on the house for a year and a half, we don’t have to worry about our amortization schedule changing significantly. Paying off my car would save me about $300 a month but would cost about $16,000 to pay off. Paying off my student loans would mean I would have to use most of the settlement money due to the high balance, but it would remove a BIG monkey off my shoulders.
Since we plan on being in this house for a long period of time, it would only make sense to rid ourselves of the PMI payment. Once we are under 80% loan to value, and with the rates that are being offered right now it would basically guarantee us that we would never have to refinance again. Next I would pay off my car, and finally I would use the remainder of the settlement that I plan on being “responsible” with, and pay down my student loans. The reason I chose to pay my car off first instead of my student loans is that the interest rate on both is the same, and although my student loans have been a burden to deal with, the amount you pay off on interest can be claimed on your tax returns as long as you are not in a higher tax bracket.
What would you do if this was you? do you agree with my analysis?
