(Updated January 2015)

Perhaps you find yourself with the pleasant problem of trying to decide what to do with an unexpected windfall of cash. Maybe you received a bonus at work, a sweet early retirement package, an inheritance or trust fund, or you hit the lottery.

Whatever the source of your newfound funds, it's always a smart strategy to use extra money to pay off debts and free yourself up from lingering monthly payments. If you have a mortgage, it may be wise to pay it off, or at least pay down some of the principal. But if you also have a home equity loan or other type of second mortgage, there's the question of which one to pay down first.

Pay higher interest, or higher balance, first?

For many people, their first instinct would be to simply pay off the smaller loan, if they have enough money to do so, and simply wipe it off the books. That would simplify your financial affairs, leaving you one less bill to pay each month, and has a certain psychological appeal as well. Or you might just whittle down the smaller of the two loans, so you're closer to paying one off entirely. But that isn't necessarily your best strategy.

Other homeowners, attempting a more sophisticated approach, might reason that their best option is to pay off as much of the larger, primary mortgage as possible. They assume that, due to the nature of compounding interest, they'll save more money over the long term by knocking a big chunk off their biggest loan, which is charging a lot of interest, rather than putting the same amount toward a smaller loan that is generating less in interest charges. But they'd be wrong.

The truth is, your best bet is to pay down whichever loan has the higher interest rate first. Period. If you've extra money you want to pay toward a primary and second mortgage, pay it all toward whichever one has the higher rate. It's that simple.

In most cases, that will be your second mortgage or home equity loan, because those tend to charge higher interest rates than on primary mortgages. However, if mortgage rates fell between the time you obtained your primary mortgage and took out your second mortgage, it's possible the second lien might have the lower rate.

It doesn't help to pay down a loan with a high balance to try to reduce your long-term interest costs if you have a smaller second mortgage charging a higher rate. That's paying off loan principle early is financially the same as putting that money into an investment that pays the same interest rate that the loan charges.

Let's say you have a $250,000 balance on a 30-year mortgage at 4.5 percent, a $25,000 balance on a home equity loan/second mortgage at 6.5 percent and $10,000 available to pay down the loans. Paying it toward the smaller loan will save you $650 in interest per year (6.5 percent of $10,000) whereas paying down the larger loan will only save you $450 per year (4.5 percent of $10,000).

It doesn't matter that it will take you longer to pay off the larger loan, because once you pay off the smaller, high-interest loan, you can start applying the money you would have used for those payments toward the larger one. So paying down the larger, low-interest loan first doesn't provide any advantage here.

About adjustable-rate mortgages

Things are a bit different if one or both of your mortgages is an adjustable-rate mortgage (ARM). In that case, it's important to to look at the specific terms of the loan and decide which to pay down first. If one of them is an ARM and you expect that interest rates will rise, consider paying that one off first, ahead of any fixed-rate mortgage.

Another possibility would be, rather than using the money to pay down one loan or the other, to use those funds to refinance both mortgages into a single loan. This is a good strategy if one or both of your mortgages are adjustable and you think rates are moving up - you can lock in a fixed rate that will never increase and avoid worrying about possible rate increases down the road. Or, if you can afford it, you could pay off one ARM completely and refinance the other to a fixed rate.

If refinancing isn't an option, you don't necessarily want to pay off the ARM that currently has the higher rate. Look at the terms of the loans and see how much they can increase over time and how fast. How much can the readjust each time they reset? How high are they capped (maximum interest rate allowed)? You generally want to pay off the more volatile of the two loans - the one with the potential to have the higher rate in a few years, rather than right now.

Some loans are more complicated, such as hybrid loans that combine a fixed rate with an adjustable rate. Fortunately, these are rarely seen these days, having disappeared with the collapse of the housing bubble.

Most adjustable loans, no matter how complex or exotic they may be, involve a scheduled transition from attractive lower monthly payments to higher payments-or from low interest rates to higher ones. While ARMs can reset to lower rates over time - and many have done so with the decline in interest rates throughout the new century so far - some are designed to adjust in such a way as to be almost sure to increase. Any loans that have higher future rates should be paid off in full, if at all possible, or at least refinanced into fixed rate loans.

The key to using your money wisely is to pay off any mortgage loans that may go higher in the future, and to refinance any notes that you can convert to lower fixed rates. This will save you cash over the long haul.

Published on June 30, 2006