Debt Payoff Strategies

Rather go to bed without dinner than to rise in debt” – Benjamin Franklin


When I first graduated from college, I faced a problem that many people face at some point in their lives – a large mountain of student debt. The primary lesson I took away from paying off my student loans is that I want to avoid debt in my life as much as reasonable. In the event that I do take on debt again, I also learned some strategies to pay it off. The situation I was dealing with and will address with these strategies is having a number of different loans that could be of different sizes and interest rates.


Minimum Payments


The most basic “strategy” is to simply make the minimum payments on each payment date for your loans. There are two situations where this approach could make sense:

1) You might be forced into this approach because after basic living expenses you have very little to no disposable income.

2) The interest rate(s) on the loans are “small”.

I’ll explain situation #2 a bit further. If the rate of return you can make on investments (after taxes) exceeds the interest rate on the loan, then in theory it makes more sense to only make the minimum payments on the loan and use your extra disposable income on these investments. This is only in theory because the vast majority of investments are not risk-free and although they may average certain rates of return, there are absolutely no guarantees. Additionally, some people (myself included) may dislike the psychological feeling of being in debt and want to pay it off faster. So if your potential investments seem to have a higher expected rate of return than the loan interest rate, the decision of how to use your extra disposable income should still depend on your risk tolerance and your level of confidence in that rate of return.

Of course the downside of this approach is that it is the slowest approach to paying off your debt and if you have a number of loans that are all of the same term length, you eliminate the opportunity to decrease the size of the your monthly payments (by paying off one or more loans early).


Prioritize by interest rate


The context of this strategy is that you at least have some income beyond the loan minimum payments that you want to dedicate to paying off your loans faster. An approach you could take is to dedicate all of these additional payments to your remaining loan with the highest interest rate. The thought behind this approach is that by paying off your highest interest rate loans the fastest, you will pay the least interest in the long run.

I think this approach is most valuable when all of your loans are of similar size. In this case there is very few conceivable reasons why you wouldn’t pay off the loan with the highest interest rate first. A loan calculator will show you the tremendous impact that interest rates can have in the long term and mitigating interest makes a lot of sense.


Rolling Snowball


Similarly to the last strategy, the context for this strategy is also that you have additional income you’re dedicating to loan payoff beyond the minimum payments. However, instead of prioritizing by interest rate, you prioritize by the size of the loan. You pay off the smallest loans first and leave the largest loans to pay off last. You shouldn’t follow this approach dogmatically; if two loans are of fairly similar size, it still likely makes more sense to pay off the higher interest rate loan first even if it is larger.

Here’s the thought process behind this approach: each time you pay off a loan, you decrease the amount you’re spending each month on minimum payments. This additional disposable income can now be used to pay off your loans even faster. It could also make sense if you simply want more disposable income each month for other reasons. I believe this approach makes the most sense when you have a decent number of loans of varying sizes and you’re focused on paying off your loans as quickly as possible. Interest rates are a less significant concern if you’re planning on paying off your loans significantly before the term length of the loans. This is the primary approach I ended up taking to pay off my student loans.


Consolidate?


If you have a number of loans, another option to consider is consolidating your loans into a single loan through a refinancing. The size of the loan will still be the same as all of your loans added together, but generally the purported benefit it that you might be able to pay less interest overall. Loan calculators freely available online should be able to help you determine if in fact you’ll end up paying less interest overall with a consolidated loan that is being offered to you. If you definitely only plan to make minimum payments on your loans and/or you only have a single loan (so you’re not doing a consolidation but just a normal refinancing) then it could be sensible to refinance/consolidate at a lower overall interest rate.

However, the downside is that if you do have a number of loans, you are preventing yourself from taking the rolling snowball strategy to paying your debt off as quickly as possible. So if your goal is to pay off your debt as quickly as possible and you’re willing to spend most extra disposable income (that you’ll get from paying off loans early) on paying off your debt even faster, then consolidation may not be sensible even if there is a fairly significant reduction in interest over the life of the loan (because the point is if you’re paying off most/all of your loans early, you won’t be paying all of that interest anyway).

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