student loan consolidation and repayment strategy

The Sherpa Mailbag: Consolidation, Big Payments, PAYE and Strategy

Michael Lux Blog, Mailbag, Student Loans 5 Comments

This morning I got an email from a reader who wanted input on repayment strategy.  Specifically, she wanted advice on making a lump sum payment and whether or not she should consolidate.  Her situation is as follows:

  • Approximately 100k in federal student loan debt
  • 5 loans at various interest rates (5.4% to 7.9%)
  • Eligible for the PAYE plan
  • Unsure of her income next year
  • Loans still in deferment
  • 15k in the bank

First, it is important to note that each loan situation is different and what works best for one person may not be what works best for someone else.  This situation is worth sharing because many people may find themselves in similar circumstances, and it will hopefully inspire some ideas.  In this circumstance, there are a number of questions to answer.

What to do with the money in the bank?

This money is likely earning very little interest and applying it immediately towards a student loan could be worth hundreds of dollars within a few months.  However, any income uncertainty should be accounted for here.  If you do not have long term employment secured, keeping a large nest egg for emergencies could prove to be a very smart decision.  There is also plenty of middle ground.  $10,000 could be applied to the highest interest student loan while the rest remains for a rainy day.

How do you decide?  It comes down to the math.  Leaving money in your bank account costs you money.  This is often referred to as opportunity cost.  By keeping that money in your bank account, you will pay extra interest during the time it sits in the account.  If you have a $15,000 loan and you are paying $100 per month in interest on that loan, the cost of keeping that money in the bank is $100 per month.

To find your best bet, do the math for several large payments that could be made.  Find out how much it costs you to keep that money in your account for the year, then check out a few different values in between all and nothing.  You want to find your personal sweet spot.  Your sweet spot is the lump sum that knocks out a bunch of monthly interest, but still leaves you with a large enough nest egg to feel comfortable.

Should you consolidate?

The problem with consolidating federal loans is that it doesn’t actually lower your interest rates.  Instead of having 5 smaller loans, you have one large loan with the interest rate calculated as the weighted average.  If you are only going to be making minimum payments for the life of the loan it does not matter.  However, if you plan on aggressively paying down your debt, you will pay less in the long run if you do not consolidate.  This is because you can pay off the highest interest rate loans first and then pay off the low interest stuff last.  If you consolidate, you just have a medium interest rate.

There are also private lenders that will consolidate your federal loans, and potentially lower your interest rate.  However, there are dangers associated with going this route.  By doing so, you would permanently lose the benefits of the federal loan, such as the repayment plans and student loan forgiveness.

For a more detailed explanation, check out our article on making the federal student loan consolidation decision.

Am I on the right repayment plan?

If you are signed up for the PAYE plan, the answer is likely yes.  When you have a number of loans and debts, it is important to find the minimum payment on each of them.  Keeping the loans current without any forbearance or deferment is critical, but you don’t want to pay any more than the minimum.  Then pick one loan to pay off.  It can be your highest interest rate loan or the smallest loan.  The important part is you pick one loan and attack it relentlessly.  Once that loan is paid off, pick the next loan to attack and repeat.

The right repayment plan will be the one that allows you to pay as little as possible on your current loans.  This frees up more money to attack your target loan.  Keep knocking off your target loans and before you know it, you will be debt free.

Readers: What do you think of this strategy?  Any changes or additional suggestions?

  • Although I do not have student loans, I wonder why it has to be so complicated. Multiple interest rates normally indicate riskier loans except in these cases. I think it should be fixed, but ther eis really no motivation to make changes.

    • That is so true. It really does seem absurd how greatly interest rates vary from one student loan to the next… the risk should be relatively constant. However, the powers that be are not bothered by this, so things stay the same.

    • I completely agree. There are so many nuances and tricks when it comes to student loans. But the loan companies love being complicated because it ends up putting more money in their pockets. Go figure.

  • If you worked to pay off the highest loan first, then the weighted average of the remaining loans should be lower, so you could end up paying less.

    • Exactly. In a case like this one, holding off on consolidation could be the best bet for the reason you stated.