Attacking Student Loans Efficiently
I am a recent college graduate, and I, like many Americans am facing tens of thousands of dollars of college debt. Rather than wishing that I had spent more time applying for scholarships, looking for cheaper schools, paying attention to my loan accounts during school (avoiding college debt can be an entire separate topic for another time), I have decided to focus on accepting what is ahead of me and optimizing the student loan payoff process to the best of my abilities. I have learned many lessons along the way that I wish that I had known before I started this journey and am hoping I can help even just one person out by sharing a few lessons learned. The single most important lesson that I learned is that paying off student loans is a war against accruing interest, and optimizing the minimum amount of interest accrued each day is the best way to effectively attack student loans.
Understanding Payment Plans and Interest Rates
The first decision that your student loan lender will force you to make is choosing your payment plan. This process at first was overwhelming to me, as the lender walked me through a number of potential payment plans to choose from and they all seemed like death traps. In my opinion, the best way to approach this is to choose the payment plan with the shortest payoff period. In the end, the shorter the payoff period, the less interest that is able to accrue over time, therefore minimizing the amount of interest paid, which is the ultimate goal. My lender offered me a slight interest rate reduction incentive if I signed up for automatic withdrawals, which is something that is very beneficial over the duration of a payment period. I ended up choosing the standard 10 year plan and signing up for monthly automatic withdrawal payments and took the small interest rate reduction.
An important concept to understand is what the interest rates truly mean. A 4.0% rate on a $10,000 loan means that over the course of a year, your lender will add 4.0% of $10,000 ($400) to your loan balance. Each loan in your account will have a principle and an interest amount, where the principle is the original dollar amount borrowed and the interest is the additional money added over time. I learned the horrors of interest as soon as i made my first student loan payment shortly after college graduation. I had read that making payments earlier than later was beneficial so i decided to put a couple hundred dollars towards my loans to get the ball rolling. My confirmation email stated “Payment towards principle: $0, Payment towards interest: $200”. 100% of my payment went to interest and the amount of money that i borrowed to go to school had decreased by $0. Interest had been accruing while I had been in school and i hadn’t even fully realized it. This realization forced me to dive into what was truly ahead of me and made me question why this information had not been drilled into my head in the past however many years of school. Although your interest rate tells you what percentage is accrued over a year, it’s compounded daily, and the daily amount can be calculated easily by [(interest rate x loan amount)/365 days in a year]. The $10,000 loan with a 4.0% interest rate is accruing $1.10 every single day. And to make things worse, as the amount of interest accrued grows, the faster it grows. For example, assuming the same $10,000 loan, with a 4.0% interest rate, and no payments made; the second year will accrue $10,400 x 4.0%, or $416. Unless a payment was made the amount of interest accrued per day grows slightly each day.
To put things into further perspective, a conservative estimate of the average student loan debt for college graduates is around $35,000 and a conservative average interest rate is 4.0%. This comes out to be $1,400/year or $3.84/day. That is $115/month for only accrued interest, so a $150 monthly payment will lower the principle loan amount by $35. And don’t forget that amount will only compound daily and $3.84/day will quickly become $4.00/day and so on if you do not take action. These numbers do not seem fair to a fresh out of college person, who is searching for a job to put their hard earned degree to use at last. There are multiple ways to attack the student loans and lower the total amount of money that is thrown away to interest, no matter how impossible it seems.
Grace Period
The typical student loan lender offers a six month “Grace Period” where a minimum payment is not mandatory. This gives students six months to get a job, get on their feet, and prepare for roughly 10 years of minimum payments. This sounds great, and is probably a very useful tool for many, but it is dangerous as the 6 months are accruing compounding interest the entire time. If possible financially, it is very helpful to begin payments the day after graduation, or even better, the day after a loan is disbursed in your name during school. Whether it be $20/paycheck during your on campus job or in between semesters job, every dollar paid before the mandatory payments saves you in the long run. Simply being aware of the status of your loans and the amount of interest accruing each day while you are still in college is a financially healthy practice, and one that I did not pay attention to. The table below demonstrates how starting payments early, big or small, can make a big difference.
In this 10,000 principle loan and 4.0% interest rate example, making monthly payments of $100 during the final calendar year of school and the 6 month grace period (total of $1800) would result in a loan difference of $1,852 and the loan would be accruing interest $0.20 less every day, which adds up to be significant over years. Any dollar amount that can be put towards student loans before the grace period ends will make the battle feel a lot less lopsided come the time for mandatory payments.
The Power of the Monthly Budget
Setting a monthly budget is potentially the greatest way I have attacked student loans since I began working full time. One good thing about being a college student for so many years, is that I was used to not having a full time income and had been living with low monthly expenses. Setting a monthly budget before receiving full time paychecks allows there to be more money left at the end of the month for student loans when you do finally start receiving full time paychecks. The more money that you allow to be put forth student loans, the less money that will be poured into interest in the long run. The minimum payment set by the lender is, depending on your payment plan selection, typically the minimum amount needed to pay for 120 months to fully pay off the loans. Doing a simple calculation of your minimum monthly payment times the number of months til the payoff date per the selected plan will show you how much more you would be paying off than the original principle amount. This is why allowing for any extra money left at the end of your monthly budget to be paid toward your loan account could potentially save you years of payments, and thousands of dollars. Once you decide how much more money you are able to pay towards loans each month, it is helpful to set up another automatic withdrawal for this money, that way you aren’t tempted to skip one of the extra and non mandatory payments. You will not become dependent on this extra money and you will be forced to live under the budget you set for yourself. Another monthly budgeting trick is that extra cash earned from working overtime, side jobs, etc. can be put forth towards loans to expedite the payment period even more. Also, most workplaces pay bi-weekly meaning that 2 months out of the year you will receive 3 paychecks rather than 2 and this is another opportunity to lower the total amount of interest paid by a significant amount.
Optimizing Extra Payments
While paying extra payments on top of the minimum payments, I learned multiple tricks about optimizing lowering the interest accrued each day. Firstly, paying extra amounts as soon as paychecks are received saves on interest over waiting til the end of the month. Every time a payment is made, big or small, the interest accrued per day is lowered by a certain fraction. A one day difference between making payments may only save you pennies on interest but over a span of 30 days, it has the potential to save you significant amounts of money. Rather than letting extra money sit in your checking account, put it towards the loans right away and knock the interest gained each day down a peg or two. This is also a good way to not become dependent on the extra money, as not seeing it in your bank account for very long will make it easier to get rid of it. Another helpful tool for optimizing lowering the interest accrual is by allocating your extra payment appropriately. If your student loan balance is broken up by multiple loans for each semester or year of school, they will most likely be different loan amounts and different interest rates. The most effective way to lower the total interest accrued per day is to allocate ALL extra payments to the loan with the highest interest rate. This is to be done until the loan with the highest interest rate is completely paid off before moving on to the next largest interest rate. It may seem like paying whichever loan has the highest balance is the one to attack first, but paying off the loans from the highest to lowest interest rate is the most effective way to minimize the total interest paid during the payoff period. Simply following this rule of thumb can save hundreds of dollars in interest over the course of the payoff period.
Track Progress
The biggest argument against paying above the minimum towards student loans is usually “why not just pay the minimum and enjoy life more with the extra cash”. I believe that tracking your progress is the best way to stay on track with your get out of student loan debt ASAP plan and avoid feeling depressed or defeated during the period of making larger payments. Tracking the principle loan value, interest paid, interest accruing per day, etc. on a monthly basis is exciting and motivating, and seeing those values trending in the right direction rapidly is one of the more satisfying feelings. The figure and table below represent the difference between paying the minimum payment ($100 in this example) vs. paying $500/month.
Obviously $500/month is a large commitment but the main point is that paying above the minimum as much as possible has potential to free up many years of payments and could potentially save thousands of dollars in the end.
Summary
Although paying off student loans is a large burden on millions of Americans, there are ways to minimize the damage caused by them. To recap, some of the tips included in this article include be aware of your balance at all times, make payments while still in school or during the grace period (however big or small), make a monthly budget and stick to it, pay off the largest interest rate loans first, don’t wait til the end of the month to make a payment, and track your progress every step of the way. Imagine the relief of seeing your student loan account reach $0 years ahead of schedule and at the same time knowing that you spent thousands of dollars less than expected. Now that is a special freedom and something worth celebrating. I cannot wait to experience it, and the grind will be 100% worth it.
