I have a $60,000 HELOC (used to pay 10% towards a first time home
purchase) with a fixed interest rate of 6.6% and a term of 15 years.
However I want to pay it back as fast as possible - in about 4-5
years.  The minimum payment is $375 per month,  but I can pay as much
as I want per month with no penalty. However, I need to choose whether
the extra payment is used to reduce the principal or the interest.
Taking into account the tax benefits of interest payments, is it
better to pay off the interest first or the principal first or does it
not really matter? My tax rate is in the 28% bracket.

Any articles to which I can be referred?

Thanks very much!

---

Clarification of Question by plumeria12-ga on 18 Mar 2005 12:14 PST

delcojoe

I gorgot to say a big thanks for your response and the link.

From what you say, it seems that designating the extra payment
(~$1,000/month) as principal allows the loan to be paid off faster. 
Not sure if total cost of loan (total payments minus tax saved in
interest payments) would be any different from designating this extra
payment as to go towards the interest alone.

peter

Your choice is likely between prepayment of principle or just making
payments in advance.  If you pay three times your regular payment
every month as payments in advance, you will pay back your loan in
five years, but you won't save a cent in interest.  The only advantage
of this is that you can skip the equivalent number of payments in the
future if need be since you have already made them.  This sort of
thing might be attractive to someone who has irregular income and want
to square away their payments in advance whenever they have an influx
of cash.

Conversely, if you make a triple payment and designate the extra as
principle, the loan would be paid off in 43 months because as you pay
the extra principal, you no longer owe any interest on that amount. 
The down side is that no matter how much extra you pay on the
principal this month, you still need to make your regular payment next
month.

One thing about your question doesn't add up. A $60k straight loan at
6.6% for 15 years should be about $526 a month.  If your minimum
payment is $375, then you either have a balloon payment due at the end
of the term, or, more likely, you have a revolving type HELOC where if
you just make the minimum payment, you either won't pay it off for a
long, long time (387 months) or you will still owe a lot of money
after 15 years (over $46k).  In order to pay it off in 5 years, you
would need to pay $1136 a month.

You can find financial calculators for this sort of thing atmany
financial web sites, but here is one you might try:

http://www.psecu.com/iTools/Calculators_Guides/Mortgage/

Sorry - I forgot to add that after 15 years, there is a balloon
paymnet due, on the outstanding amount, as you suggest.

The short answer is that paying off debt (principal) is virtually
always the right thing to do when considering what to do with extra
cash (by extra, I am assuming one already has already accumulated
reasonable emergency cash reserves).

It is difficult for me to conceive of a scenario in which there is any
actual savings associated with paying interest instead of principal. 
When you pay $1000 of principal, you save $66 per year in interest. 
If instead you pay the interest (make a prepayment, which does include
some principal - little at first but more later on), you 'save' 28% of
that $66 because you get to pay it with tax free dollars.  That means
that your out of pocket expense for that interest payment is only
$47.50, BUT, and it is a big but, you then have to pay that $47.50
year after year until the principal is paid off.  If you pay an extra
$1000 of principal in the first year of a 15 year loan, you are going
to save yourself $47.50 a year for 14 years (more or less) - even
after considering the tax 'savings'.

There is always an exception to any rule, and the exception to this
rule might be an unlikely scenario where without some additional
interest expense you wouldn't be able to itemize certain expenses in
certain years.  Even that sort of thing would be a stretch and it is
highly unlikely to apply to a homeowner with a mortgage since you are
always going to be paying interest - the only questions are how much
interest and for how long.

Here is a pet peeve of mine:  a lot of people pay extra principal on
their mortgage early on because they are saving a lot of interest. 
After a while, they get their loan to the point where less than half
of their monthly payment is servicing interest, so most of their
payment goes towards reducing their principal.  Not long after that
point, some people reason that there is no point in making extra
payments because "I am hardly saving any interest now".  That is
ridiculous, you are saving the exact same amount per year with those
extra payments, it's just that the amount of time between when you
elected to pay extra and when you would have had to pay that principal
anyway is much shorter.

This brings us back to where I started, paying the principal is almost
always the best thing to do.  Of course that assumes that there are no
prepayment penalties.