A few months ago Quint and Daniel answered a question about handling student loans, which you can listen to HERE, and today I’d like to dive a little deeper into that. DIY Money has a more positive attitude when it comes to student loans. If you need to take out a 30 or 40 thousand dollar loan to get paid an extra 50 thousand dollars a year that’s a good investment. Debt is never good but an education is one of the best investments you can make. Like any other debt, getting organized is usually a good place to start.
1) Get on a Budget
The first part of being organized is getting on a budget. Quint and Daniel have talked about this on the show before, it was actually the topic of their first episode, because they believe in being organized that much. Now a lot of people jump the gun on budgeting, they’re excited and they want to start being more financially responsible. I love that attitude, keep it, but it’s hard to budget when you don’t know where your money is going in the first place. Spend a month keeping track of all your expenses, where is your money going, how much do you spend on rent, food, bills, etc. A lot of people rely on technology to automatically take care of these things and don’t know the exact amount they’re spending on these items.
Now that you know where all your money is going you can make a budget for the second month. How much did you spend on eating out? Set aside an amount to spend on everything, say you set aside $200 dollars for eating out a month, if you use it in the first week well now you’re eating at home for the next three weeks. Make your budget and stick with it. Budgeting is more a behavioral adjustment than a mathematical one.
Quint and Daniel have suggested before on the show that you have an emergency fund set up to get you through hard times. Budgeting is great, but you can never plan for everything, your car could break down, your water heater could break, whatever it is you may need more than what you’re living on for a month. Saving up enough to cover all your monthly expenses for three months is usually enough to get you through most emergencies, but at the very least enough for one month is a good place to start. The final goal of budgeting is to create as much margin as possible. This is the difference between your income and and your expenses and the wider that gap is the more money you have for saving, investing, and paying off debt.
2) Tiers of Debt
If you’re on a budget and you’ve got your emergency funds saved up, you’re probably ready to start tackling your debt. Dave Ramsay has a strategy for managing debt he calls “The Debt Snowball” method that works pretty well. This method suggests you start paying off your smallest debt first and work your way up to the bigger ones. Knocking out these smaller debts will help you feel like you’re making progress and help clean up your finances at the same time. Quint’s mentioned on the show before that he likes to categorize debt into different levels.
The first level is your most financially damaging debt, most notably credit card debt. Hopefully your credit debt is your smallest debt, but even if it’s not it may be a good idea to start here first. Credit card debt can have a much bigger impact on your credit score and finances than a student loan. Loans are designed to be paid off over time with monthly payments and while we definitely want these paid off as soon as possible, credit card debt isn’t designed for this long term paying off. Credit card debt can suffocate people and getting it squared off first is generally a good idea.
The second level is your car loans, student loans, mortgage, etc. All these are designed for longer term payments and won’t hurt your finances on a day to day basis. At this stage these should all be accounted for in your monthly budget and are going down slowly. Of course we all want these paid off as soon as possible so there are a few strategies you can use to make paying them off easier.
3) Strategies for paying off loans
Most student loans have an option where you can lower your interest rates by about 0.25% if you sign up for automatic payments. If you’re on budget and have been keeping to it for a few months this shouldn’t be too big of a step up. You’re still making the same payment but your debt is building slightly slower. Don’t get complacent with automatic payments though, keep track of them in your budget and never forget to account for them. 0.25% isn’t going to make or break your interest rates but every little step adds up.
Another important thing to keep in mind is what are your future life plans. Do you want to own a house, do you want to start a business, do you want kids? All of these are going to cost some money and you may not have the funds for these if you put all your extra margin into paying down student loans. Daniel previously suggested on the show that you can open a high yields saving account and put your extra margin in there. Then once or twice a year you can withdraw from there and use it to make bigger payments on your loans. Alternatively if you want some of those other things you now have the option to allocate that money to them instead. There are different rates for different banks out there you can look into. Daniel uses Ally Bank and their savings yield is 1.60%, while Quint uses Capital One and their rate averages at about 1.70%.
An alternative strategy to making these bigger once a year payments would be to commit some of your monthly margin to increasing your monthly payments. You can always pay more than your minimum amount and if you feel like you’re financially stable and have enough margin that you can commit more money to those payments this will be the fastest way to decrease how long you’re paying off loans.
Let’s say you have a student loan for $40,000 at a 6% interest rate that needs to be paid off in 10 years. If you just make the minimum payments on that loan for the next ten years your monthly minimum will be $444, and you’ll end up paying a total of $53,290. If you do the automatic payment and lower the interest by 0.25% then it’ll be $439 and $52,689. That’s not a huge difference, but you have to make the payments every month anyway you might as well decrease them however you can. Let’s say then you have extra margin and you feel comfortable paying 20% extra on the monthly minimum, or $87 to $526 a month. If you did all that you’d finish paying the loan 25 months earlier, more than two years, and you’d only pay a total of $49,861. Total all of this has saved you about $3,429 and you’re out of debt two years earlier!
Not everyone is going to have enough margin to be able to pay a lot extra a month but every dollar counts. The important thing is, again, what is important to you, do you want those two years of being debt free? For some people they’re really going to want that, for others they may decide they’d rather pay the minimum and have the extra margin for other things in their life like kids, a downpayment, or investing. If you had enough income you could even do all of these, but likely most people may have to pick and choose one or two of these. Ten years is a long time too, your income could very likely go up and maybe five years into your loan you start paying extra on the margin, great you’re still saving time and money, maybe less but you have to do what’s right for you.
Unfortunately there’s no magic secret to paying off debt. What it takes is discipline and planning. Track your expenses, make a budget, tighten your purse strings where you can to increase your margin as much as possible and then you can begin to use that margin to pay down your debt if you don’t want to wait years for the monthly payments to add up.