A Student Loan Repayment Strategy
Student loans can be tricky to repay, especially if you know little about finance, but there are some golden rules that are fairly easy to follow and will save you a lot of time, and money.
Let’s say for instance that you have 2 loans:
Loan A - $2,000 has an interest rate of 8% per year, or 0.67% per month.
Loan B - $8,500 has an interest rate of 5.5% per year, that is 0.46% per month.
On the very first month of your repayment, the interest for Loan A will be $13.33 while the interest for Loan B will be $38.96. You might be tempted to repay Loan B faster, since it seems to cost you more each month. But it’s not the way loans work; think long term.
Let’s consider that you only repay the minimum payment for loans A & B, over a period of 10 months:
*note that the minimum payment is determined by your lender. Each lender has its own formula.
At the end of the 10 months, you paid a total of $250 for Loan A, $129.77 of which went to interests. This means that you only repaid $120.23 out of the $2,000 principal.
Similarly, you paid a total of $700 for Loan B, $383.10 of which went to interests. You only repaid $316.90 out of the $8,500 principal.
There’s something wrong here: about half of your payment, each month, went to interest!
So let’s consider that each month, you have a discretionary income of $100 that you want to use to repay your loans faster. This is what happens when you place your extra $100 on loan B only:
Instead of paying $383.10 in interest over the course of the 10 months, you only pay $362.22, which represents $20.88 in savings. And notice that your principal is much lower at the end of the 10 months (which is good, in case you’re not following).
This is maybe the most important rule of loan repayment: if you pay more than the minimum payment each month, you save money on interest!
It follows that, it you can afford to pay more than the minimum payment each month, you should absolutely do that.
But maybe you’d like to save some of your income instead of repaying your loans? You should, indeed, try and save some cash. But consider this:
For every dollar that you put aside at a 1% savings rate (+$1.01)… you could have avoided 8% interests from your loan (-$1.08). Do the math: you lose 7 cents per dollar per year. So unless you find a non-risky investment that steadily returns 8% or more—good luck—you should stay focused on repaying your loans.
It is strategically important for you to decide how much cash you need to save every month, so you can use everything else to repay your loans.
Everything else? How about having a life? you will ask.
Nah. You’ll have a life when you’re done repaying your loans.
WAIT. The demonstration is not over.
You could have saved even more had you placed your extra income on the loan with the highest interest rate. Loan A:
By placing your extra $100 on Loan A, every month, you ended up only paying $99.23 in interest over the course of the 10 months, compared to $129.77 in the scenario where you only paid the minimum. That is $30.54 in savings, $9.66 more than when adding the $100 to Loan B!!
This is the second most important rule of loan repayment: if you have several student loans, and enough income to pay more than just the minimum payment, you should repay the loan with the highest interest rate first. Only pay the minimum payment on all your other loans.
Do not trust your lender to do this for you. In fact, several lenders’ websites are set to trick you. If you let your lenders decide where to allocate your extra payment, they might very well place it on the loan with the highest balance (why not?), and not the loan with the highest interest rate. That’s because they think you suck at math.
Better yet, if you’ve been paying more than the minimum, they may decide that, because your are ahead of your scheduled payments, you do not owe money for a while… and therefore postpone your automatic payments! Make sure to check your account settings as they will likely default to the opposite of your best interest.
Such deceptive practices are frequent. Watch out for a company called Nelnet, for instance. They are the ones who claim they are here to help you reach your financial goals. BS.
Your lenders know that by not taking your money now, they will take more of your money later… Return on investment.
This is the golden rule number 3: Do not trust your lender. Build your own spreadsheets. Manually allocate your payments, and come back a few days later to make sure everything is where it should be.
Here you might think “That’s too much of a hassle. And for what, $9.66? I’d rather not worry about it.”
Take a look at this spreadsheet. It presents a loan repayment strategy for someone having a total of 6 students loans, with a principal of $34,950 and interest rates ranging from 5% to 6.8%. There are tabs at the bottom mapping out different scenarios:
In Scenario 1 - Minimum payment, the person is only repaying the strict minimum each month. In this scenario, it will take 11 years and a few months to entirely repay the loans. The total paid, at the end of the 11 years is $49,757.69. Yep, that is $14,807.69 paid in interests. 42% more than the amount that was loaned.
In Scenario 2 - Optimized payment, the person consistently repays $800 every month, by placing as much as possible on the loan with the highest interest rate. Wait for it: not only are they able to repay their loans in less than 5 years, but they only pay a total of $43,037.92, including $8,087.92 of interests. “Only” 23% more than the amount loaned. The faster you pay, the less interest you pay.
By paying more than the minimum payment every month, and placing any extra money on the loan with the highest interest, this person saved $6779.77.
Well worth logging into your online account twice a month to ensure that Nelnet (or whoever you’re dealing with) is not scr*wing you.
The spreadsheet is up for grabs. Go to File > Downloads as > Excel, and start using it for your own student loans.