Mailbag: What’s the Best Way to use my Inheritance to Attack my Debt?

Michael Lux Blog, Lower Payments, Mailbag, Student Loans 1 Comment

If you are fortunate enough to come into a large sum of money, be it inheritance or a large bonus at work, there are a couple of ways to effectively deploy it against your student loans.  One of the members of our forum was curious about the best way to utilize a lump sum when faced with many loans at various interest rates.

We were given the following information:

I currently have about 80k in student loan debt, about 63k of private loans and 17k of federal ones. I don’t have great credit so I haven’t even tried to consolidate them. I have about 6 different private loans, with interest rates ranging from 5% to 10%. I recently inherited 50k and want to use it to pay of as much of my loans as I can. My question is, how can I best use this money to maximize it’s potential? Should I use all of it to pay down my two highest interest loans? Should I at least put 5k on the lower ones to help pay down the principal? I guess I should do the math and play out different scenarios, but I’m curious if there’s any catch or trick I’m missing. Just say if I distributed it evenly among all of them, how much of a decrease would I see on the minimum monthly payment? Any advise anyone could provide would be greatly appreciated.

Thank you!!

The Purely Fiscal Strategy

If you are looking for the approach that will save you the most money in the long run, it would be to pay off your highest interest loan.  Whatever money is left over, apply to the second highest interest loan, and so forth.

If you look at the breakdown in your monthly payments, you will probably note that a bigger portion of each payment is applied to interest with the higher rate loans.  By charging more interest, the lender is making more money, and you will being paying off the loan longer.

The lump sum changes the game in that regard.  Paying all of that money up front either eliminates a balance or dramatically reduces it.  Either way, attacking the high interest debt first ensures that your monthly payments in the future go the furthest.

The only exception to this approach being the most efficient from a dollars and cents standpoint would be if there was some sort of prepayment penalty on the loans.  It is not unheard of, but they are pretty rare and hopefully don’t apply to your situation.  Checking with your lender is the only way to make sure.

Reducing the Minimum Payments

Based upon the questions, it seems that using the money to make the minimum payments more manageable is a goal.  It is also a good idea.

Unlike credit cards, minimum payments do not change based upon the balance of your loan.  If you owe $109 per month on one of your loans, it will still be $109 per month even if you knock the balance in half.  The only thing that changes is that you have less payments of $109 to make before the loan is paid in full.

That means if you want to use your lump sum to lower your monthly student loan obligation, the most effective way is to use it to pay off as many debts as possible.

Paying off the highest interest loans is still the preferred route, but it can be tweaked within reason.  Suppose loans A and B have the highest interest rates and you can pay the off entirely.  You are then left with 10k to pay off the remaining four loans.  If loan C has a balance of 15k and an interest rate of 6.8% and loan D has a balance of 10k and an interest rate of 6.5%, you might consider skipping over loan C and just paying off loan D.

By eliminating a loan entirely, you eliminate the payment, and it makes your inheritance feel like it went further.  Using this option would cost only slightly more in interest in the long run, but from a psychological standpoint, it feels like a bigger win.  If putting a much bigger dent in your monthly minimums helps you better manage your finances because you are more motivated, it is definitely worth considering.

A Rainy Day Fund

One other use for some of the lump sum would be to set some of it aside for a rainy day fund.  You will end up paying more in student loan interest if you leave a portion of money in the bank, but it is a great resource to have if you run into unexpected car trouble or medical bills.

One Thing to Avoid

When you make a huge payment on your student loans, some lenders may count it as future payments for the next several months or years.  You may get statements that say you have a $0 due each month.  By not charging you anything for a large period of time, your lender is trying to get the balance built back up through interest.  Remember, they profit through interest, reducing the principal just means they are getting the money back that they gave you years ago.

While it is nice to have the option not to pay if your finances are really tight one month, it is dangerous to just let the balance sit.  If this happens with one of your loans, the best practice is to continue to send in your monthly payments.  Treat it as though nothing changed and stay on top of the loan.