The Investment Scientist

How to Pay Off Debts

Posted on: September 12, 2013

images-16A client I visited shared with me that he is very burdened by his debts. He has a primary mortgage, a secondary mortgage and a personal loan. He asked me whether he should pay off the debts and in what sequence. That’s a fantastic question.

Here are the partial details of his debts (I’ve concealed the amounts).

  1. The primary is a 15 year fixed rate mortgage with a rate of 3%.

  2. The secondary is a 5 year ARM with a current rate of 2.5%.

  3. The personal loan has a rate of 5%.

Here are my recommendations to him.

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Keep the fixed rate mortgage.

Since mortgage interests are tax deductible and my client is in the highest tax bracket – combined federal, state and local he is paying close to 50% – his effective cost of money for the primary mortgage is about 1.5%. This is even less than inflation and far less than what Greece is paying!

On top of that, carrying a fixed rate mortgage is like having an inflation hedge. If, God forbid, inflation rates go up to 5%, and his is only paying 1.5% effective interest rate, he is making off with 3.5% in returns by keeping the mortgage.

Watch the ARM (adjustable rate mortgage).

The ARM worries me a little bit, since after the five year lock period, the rate becomes adjustable. If again, God forbid the inflation rate goes up to 5%, you can be sure the ARM rate will be higher than 5%. At that time, he will want to pay it off as quickly as possible. But before that happens, he wants to just sit tight and let me watch it for him.

Pay off the personal loan.

The personal loan has the highest interest rate. On top of that, the interest payments are not tax-deductible, unlike mortgage interest. This is the most costly debt. It’s a double whammy that he should get rid of as soon as possible.

The advice above is easily worth $100k to him if carried out religiously. What’s priceless is that my client also gets the peace of mind that he is handling his debt situation in the smartest possible way.

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Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.


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