extra money? which loan?

I have X Dollars, Which Student Loan Do I Pay Off First?

Michael Lux Blog, Strategy, Student Loans 1 Comment

If you are the lucky recipient of a bonus at work, an inheritance, or a gift from family; that money can go a long way in the battle against student debt.  The problem is that many borrowers have several different loans.  Even if you don’t have thousands of dollars, paying a little extra each month can make a difference.  The key is to pick a single loan to attack.  Choosing the right loan to attack is a critical decision.

Unfortunately, there really isn’t a one size fits all approach to making this choice.  That being said, there are several major factors that need to be considered.

Private vs. Federal Student Loans

In most cases, paying down the private student loans first is the smart move.  This is because federal student loans come with borrower protections such as income-driven repayment plans and student loan forgiveness programs.  Even if you don’t think you will ever need to utilize these programs, they provide a good insurance policy in case of a rainy day.  For example, if you lose your job, federal loans allow signing up for an income-driven repayment plan with $0 monthly payments.  This is a protection that private loans can’t match.  If you are not sure whether your loans are federal or private, the Department of Education’s Student Loan Database keeps a record of all federal loans.

If the interest rates are close, pay down the private loans first.

High Interest Rate Loans vs. Low Interest Rate Loans

This is the obvious factor.  The big hurdle to eliminating student debt is the daily battle against interest.  With each passing day, your balance grows.  For loans with high interest rates, it is possible for only a tiny percentage to actually lower the loan balance while the rest goes towards interest… aka lender profits.

Paying down the highest interest debt first will save the most money in the long run.

Small Balances vs. Large Balances

Suppose you have $5,000 to used towards your student loans and three loans with the following balances: $1,000, $4,000 and $10,000.  If that $5,000 is used to pay off the two small loans, that eliminates two loans entirely leaving just one behind.  For borrowers with loans from many different lenders, that means eliminating a monthly bill and freeing up some extra cash each month.  This can also improve a borrowers debt-to-income ratio as two debts will be paid off on the credit report.  Simply reducing a balance has no impact on your monthly bills or your debt-to-income ratio.

Reducing a balance is a great feeling, but paying it off entirely is the best.  For many people, successfully eliminating a loan can help provide motivation to eliminate future loans.

Because of the benefits of loan elimination, even if a large loan has a slightly higher interest rate than the smaller loans, it could be advantages to eliminate the small loans first.

Other Factors to Consider

  • Cosigners – If you have two loans and can’t decide which one to attack first, your cosigner may appreciate you eliminating the debt that they are attached to.  Even if you are making all of your payments, the student loan will still be on your cosigner’s credit report until it is paid off completely.  Plus, if you encounter problems down the road, you don’t want those issues to also hurt your cosigner.
  • Refinanced Loans – Borrowers with a solid income can credit score can lower their student loan interest rate to just under 3% by refinancing.  Having this option available may mean that extra cash may best be used towards a retirement account.  If you can earn 7% on the money but only pay 3% on the debt, you come out ahead.  The risk is that investments don’t do as well as you hope.
  • Getting Rid of a Specific Lender – If you have one lender that is a thorn in your paw, paying down their loan first is worth considering.  Eliminating their loan means you no longer have to deal with that lender and it means they stop profiting from your debt.  That can be very satisfying.

Bottom Line

In most cases, when you have extra money to put towards your student loan, paying down the highest interest rate loan first is the preferred approach.  However, the decision isn’t always that easy.  If the interest rates are relatively close, there are a number of other factors to consider in deciding which loan to knock out first.