If you come in to a large amount of money — whether through an inheritance, bonus at work, or winning some money — putting it towards your student debt can be a great idea.
Before you send that big chunk of money off to your lender, planning out your strategy is an essential step.
Be Smart About the Loan You Attack
If you have multiple student loans, there are a couple approaches that can use with your big payment.
Option 1: Pay Down the Highest Interest Loan – This one is usually the recommended approach. The plan is very simple. Use whatever extra money you have to pay down the balance of your student loan with the highest interest rate. Mathematically, this is almost always the most efficient use of your money.
Option 2: Pay Off a Loan in Full – If you have enough money in your large payment to pay off a loan in full, this can be a very tempting option. Paying off a loan completely will eliminate a monthly payment for you going forward. This win can help your monthly balance sheet, provide some financial flexibility, and help you find the motivation to attack the rest of your student debt.
What not to do: Split the payment evenly across all of your loans – Doing this is better than doing nothing, but it is a lousy strategy. It lacks the interest saving power of option 1 and it lacks the flexibility and motivation of option two.
Don’t Forget Your Emergency Fund
Having an emergency fund in place is critical to smart financial planning. The general recommendation is to have three to six months worth of expenses saved away in case of an emergency. For people with lots of student debt who do not have children dependent upon them, this number can get shaved down a bit. An individual’s ability to find new work or additional income quickly will also impact how much money should be set aside in an emergency fund.
While there is some room for debate about the proper amount to set aside, there is no debating the necessity of having an emergency fund. With an emergency fund in place, you can more easily deal with a job loss, car trouble, or unexpected medical expenses. Without an emergency fund, one problem can quickly become many.
When you have a large sum of money, before making your big student loan payment, make sure you have enough funds in your emergency fund.
Keep In Mind Your Other Financial Goals
The strategy here goes beyond just your student loans.
If you are saving up to buy a house, the approach can be more complicated. For some, the best use of this extra money would be to save it towards the down payment on the house. For others, paying off a student loan in full may be a necessary step in order to get the home loan they want. A reduction in your student loan balance without actually lowering your required monthly payments will likely not be very helpful in your pursuit of a mortgage.
If you are fortunate enough to come into some unexpected extra money, using it towards your student loans is a very wise decision. However, it is important to spend a few minutes to think through your strategy to make sure you are getting the most out of your extra money.