I’ve read and heard many advice regarding paying off student loans and there seems to be two camps when it comes to the best way to pay off your loans.
There is the camp that believes paying off the smallest loans first is the best way to pay off loans. Yes, you may pay more in interest, but psychologically it helps. In some cases, this is true. Even Dave Ramsey suggests to pay off your loans from smallest to largest.
In a life of a loan that can range between 2 – 30 years, does it matter if you save $200 in interest? Would you even feel the benefit? What if you can save $2,000 in interest? Would this change your views?
Then there is this other camp that believes paying off the loans with the highest interest rate is the best way to go. If you do the math (which I’ll show you below), paying off the loans with the highest interest rate first will always yield the lowest interest paid. This is the fastest way to pay off your loans.
Think of the interest rate as the rate you are bleeding out. If you had three wounds and only two hands to cover two wounds, you should probably cover the two wounds that are bleeding out the fastest. Yes I know this is a weird and grim example. I’d probably call 911 first and wonder how I ended up with three wounds. But I hope you get the point!
Despite the amount of articles I’ve read about student loan calculation, I’ve never really seen anyone paint a picture, so I’ve create three scenarios to show what it can look like.
All these scenarios will include a version where you only make minimum payments. In this case, it doesn’t matter if you’re paying off the smallest loan or highest interest rate loan. These strategies only apply to payments greater than the minimum payment due or extra payments.
To keep everything equal, all my extra payments will be $500 greater than the minimum payment due per month. For example, if the minimum payment for the month is $400 then my total payment for the month will be $900. (Fun fact: if you make extra payments every month, your minimum payment due will decrease every month)
Also, I made the term of all of these loans 80 months. Why? No reason, move on. The start date for these scenarios is June 2017.
If you couldn’t tell, I like to lay out everything in excel. So, let’s take a look at those scenarios that I played out with the repayment calculator.
Three student loans
Prioritizing between smallest loan and highest interest rate loan is around a $600 difference. I would take $600 any day. The question is would you feel that benefit over the term of 4 years? Notice the average interest rate for the Smallest Loan Scenario is the largest. It’s because the largest loan has the highest interest. If you put the least priority on that loan, you spend more time paying that interest rate. Either way, DON’T pay the minimum.
Credit card debt and student loans
Here’s a scenario where you really get to see the effect of paying off the highest interest rate first. The difference between the first two scenarios is over $1,600. That’s a decent vacation or a nice guitar. The larger the smallest loan is and the greater the differences are in interest rates, the greater the differences will be in total interest paid (what a sentence). Either way, DON’T pay the minimum.
Credit card debt, car loan, and student loan
In both scenarios, the credit card debt has the highest priority since it is the smallest loan and has the highest interest rate. After that is paid off, the priority is between the car loan and student loan, which roughly have the same amount and same interest rate. Therefore, the difference between the two is negligible. Either way, DON’T pay the minimum.
Did you notice a pattern? Don’t pay the minimum… but more often than not, there is no other choice. When I graduated from college, I had no choice but to pay the minimum. But as soon as I could, I made extra payments and I encourage you to do the same. These scenarios have an overarching assumption of $500 in extra payments only to compare apples to apples. Your situation will be different. Make those extra payments and your future self will thank you.
Want to see other scenarios? Leave a comment below!