option responsible borrowers overlook

The $1000 Mistake Made by Responsible Borrowers

Michael Lux Blog 0 Comments

Repaying student loans is a long difficult marathon.  Smart borrowers know that the interest on the loan is the real enemy.  Payments towards interest do not lower the balance owed; interest payments are simply lender profits.  For this reason, many responsible borrowers pay a little extra each month towards their loans.  These extra payments attack the principal balance, get the loan paid off much faster, and save a small fortune on interest spending.

The Power of Paying Extra Towards Student Loans

The average student loan borrower has around $30,000 in student debt.  To make the math easy, lets assume that our borrower has three loans with a balance of $10,000 each.  Interest rates can vary greatly from one borrower to the next, so our example borrower will have a low interest loan at 3%, a medium interest loan at 6%, and a high interest loan of 10%.

If our borrower is on a ten year repayment plan and pays the minimum for the life of the loan, the total spending will look like this:

LoanOriginal BalanceInterest RateMonthly PaymentTotal Spending
Loan A$10,0003%$96.56$11,587.29
Loan B$10,0006%$111.02$13,322.46
Loan C$10,00010%$132.15$15,858.09

One of the big issues with making the minimum payment is the beating that most borrowers take on interest.  In our example, our borrower will spend well over $10,000 on student loan interest.  However, if our borrower is being responsible, they will decide to pay a little extra on their debt to get it paid off faster.

Suppose our borrower pays an extra $50 each month for each loan:

LoanOriginal BalanceInterest RateMonthly PaymentTotal Spending
Loan A$10,0003%$146.56$10,977.98
Loan B$10,0006%$161.02$12,004.04
Loan C$10,00010%$182.15$13,423.33

By paying an extra $50 per month on each loan, our borrower is able to save a whopping $4,362.39 on student loan interest alone.  Additionally, by making the extra payments, instead of living with the debt for 10 years, our borrower has it completely eliminated more than 3 years earlier.  For borrowers with larger debts or higher interest rates, the potential savings can be significantly larger.

Due to the large potential savings, many borrowers wisely opt to pay a little extra each month.  Unfortunately, this is where most responsible borrowers stop.  If they got a little creative, that extra $150 per month could be used even more effectively.

Paying Extra Towards Your Student Loans the Smart Way

Rather than putting an extra $50 towards each loan, suppose our borrower used that extra $150 towards the highest interest rate loan.  Once, the highest interest rate loan was paid off, the money that normally would have been paid towards the high interest loan gets applied to the medium interest loan.  This pattern continues until the debt is paid off in full.  The repayment strategy is commonly called the debt avalanche method.

Here is how the total spending shakes out:

LoanOriginal BalanceInterest RateTotal SpendingTime to Payoff
Loan A$10,0003%$11,282.44~7 years
Loan B$10,0006%$12,184.59~5 years
Loan C$10,00010%$11,901.67~3.5 years

By shifting to this strategy, our borrower spends exactly the same amount each month as in the previous example.  However, by focusing on the high interest loan first, total interest spending for all three loans combined drops by over $1,000!!  The entire debt is also paid off slightly faster.

The advantages to this approach go beyond the massive interest savings.  By paying off the high interest rate loan in its entirety in just 3.5 years, our borrower is in much better financial shape than someone who just paid an extra $50 each month.  If after four years our borrower tries to buy a home, they will have an easier time qualifying for a mortgage due to the improved debt-to-income ratio.  This is because credit evaluations look at monthly minimum debt bills compared to monthly income.  By eliminating a loan entirely, borrowers improve their creditworthiness.

This approach also generates some flexibility for our borrower.  Suppose after 5 years there is a huge recession and our borrower loses their job.  Because the high interest loan will be paid off in full, the remaining minimum monthly payments are a total of $207.58.  Had our borrower just paid $50 extra towards each loan, the required minimum monthly payment would still be the full $339.73.

Other Approaches to Attack the Debt

The Snowball Method – This approach is very similar to the avalanche method, except that borrowers target the loan with the lowest balance rather than the loan with the highest interest rate.  Financial gurus like Dave Ramsey often advocate this method.  The advantage is that borrowers get a few easy wins early in their repayment journey.  The hope is that it provides ongoing motivation going forward.  The problem is that it is not the most efficient way to eliminate debt because it does not minimize interest spending.

The Refinance Shortcut – Rather than dealing with high interest loans at all, some borrowers are able to refinance their student loans with another company and lock in a lower interest rate.  This approach can mean huge savings for the borrowers who are able to qualify.  Unfortunately, a solid credit score and income are a necessity.  At present, some of the best refinance rates start at around 2.5%.

Bottom Line

Paying extra to eliminate debt is definitely the smart move and it can result in some massive savings.

However, if you are going to do the responsible thing, go about it in a smart way with a coherent strategy.  Paying extra is good, paying extra in a smart way is even better.