Chipping away at large loan, or get rid of smaller ones? Student debt

Question

I am currently $50k in debt from school. I have $9,500 in saving specifically saved for paying off student loans. I am wondering if I could get some quick advice as to what/why I should be paying off.

Here is my loan situation:

1. $20k loan at 9% interest to come in Dec; Discover, private.
2. $7.5k loan at 6% that I am currently paying off @ ~$200 month; Perkins, federal.
3. $23k loan at 3-4% currently paying off. Federal.

I am really wanting to pay off my 2nd loan because I can hit it in one shot right now. I would lose the monthly payment and I would be able to put that towards my Dec loan which I plan to focus ALL extra money to.

My question is this, does it pay to focus NOW on the higher interest rate loan? If I pay the 6% I will be losing more money on interest... but I would have more money to pay it off because of the 2nd loan being gone.

My current salary/expenses won't be changing for at least a year (as far as I can see)

Answer 1

It's very simple, line up your debt in the order of interest rate, tax adjusted, and start with the highest rate.

Too simple? If knocking off the $7500 loan feels better to you than the fact that you are still paying 9% on $7500 (as part of the $20K) makes you feel bad, just pay off the $7500. I'd rather be ahead $210/yr. (A celebrity advocates the small wins promoting good feelings and encouragement. If that actually works for some, I won't criticize it here)

If freeing up the $200/mo payment enables you to do something else that's beneficial, that's another story. I've written how $10,000 of student loan can keep you from qualifying for $30K or more of mortgage.

In isolation, highest rate. With the rest of the picture, other advice might be more suitable.

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Answer 2

There are two solutions. One is financially better, the other is psychologically better.

Financially better: You should pay off loans in the order of interest rate, so the 9% first, then the six percent, then the 3-4%. If you pay back $1000, the first one saves you $90 a year in interest, the second saves you $60, the third $30-$40 a year. Every year until everything is paid back.

Psychologically better: Some people have psychological problems paying back debt, and it is better for them to pay back small loans first. If you feel better having two loans instead of three, and feeling better makes you able to save money and pay back the other loans, while having three loans would make you depressed and unable to make savings - pay back the smaller loan.

If you don't have that kind of problem, use the "financially better" method.

Answer 3

The other responses are correct in that financially, you should pay off the highest-interest-rate debt first, while paying the minimum on any lower-interest-rate debt to avoid any fees or penalties.

However, there is one more trick you might consider: Unless you have the $20k available to pay the Discover debt immediately (and you say you have $9.5k so far), you could roll over your private debt over to a new card with a lower interest rate.

It's pretty common to find balance transfers deals that charge a 3% transfer fee to have 0% APY for 1 year. If you are an organized person and are sure you won't forget to balance transfer again in the future, this would bring your private debt down to ~3%/year, and make your highest effective interest rate the $7.5k debt at 6%, and you could pay that down first.

That's the extreme version, and requires you to set a calendar alert 10-11 months in the future. A less-extreme tactic would be to try to switch your private debt once to a lower rate - you probably could find a card with 0% APY for 1 year and then 7-8% afterwards, without continuing to balance transfer in the future. Then it would be closer to negligible which debt you chose to pay down first (between private and Perkins), and in that case I'd advocate finishing off the smaller debt entirely (because it would be the highest rate at that moment, and to feel good about knocking one off, and to reduce the number of fees and credit score hits if you ever took a vacation and was late on a monthly payment).