Debt Advice – Debt Payment Order Question

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Debt payment order for Nathaline

DFA Reader Nathaline wrote:

I am currently in debt with a car loan and a student loan. The interest on the car loan is 4.99% and the student loan rate is 5.25%.

Student loan:
I started repayment for the student loan in July 2008, with a starting balance of $22,565. In 2010 I consolidated my student loans with a new balance of $18,174. The current balance is $17,147. The minimum student loan payment is currently $149 – I pay an extra $50 to $100 each month depending on what is happening in my life.

The auto loan:
I financed the car loan in August 2010 for $17,477. With an interest rate of 4.99%, my minimum payment is $330. The current balance of the auto loan is $15,656.

My big question:
I have an extra $200 in my monthly budget to make extra payments, so where should my focus be? Should I direct $530 (330 +200) to the car loan or $349 (149+200) toward the student loan?

Pay off debt like this…

Hi Nathaline – congrats on having an extra $200 each month to put toward debt.

Normally I always advise paying the highest interest debt off first.  Let’s do the math to see if that position works best for this situation.

Nathaline has a total of $679 to put toward debt each month.  There is only a 0.26% difference in interest rates between the two debts, but the difference in minimum payment amounts is large – but does that make a difference?  Let’s do the math for each scenario.

These calculations are based on a consistent $679/month ($200 extra) debt repayment.

Student loan then auto loan

  • $149 + 200 = $349 toward the student loan
  • $330 toward the auto loan
  • Total weeks to pay off debt = 55 (auto loan in 53 weeks and student loan two weeks later in week 55)
  • Total interest paid = $4,018.06

Using this approach both loans will be repaid in 55 weeks.  The auto loan will still be repaid first – in week 53 – since the minimum payment is so much higher… but the student loan will be repaid only 2 weeks later in week 55.

Auto loan then student loan

  • $330 + 200 = 530 toward the auto loan
  • $149 toward the student loan, until auto loan is paid off at which point all $679 will go toward the student loan
  • Total weeks to pay off debt = 55 (auto loan in 32 weeks and student loan in week 55)
  • Total interest paid = $4,061.01

As you can see, there is little difference to paying one loan off before the other.  Both approaches will pay off debt in 55 weeks, but there is a small savings to be had.

The answer

If the $200 is put toward the student loan first Nathaline will save approximately $43 in interest costs over the life of both loans.  Although the difference is small, every penny counts.  That said, if Nathaline would benefit from seeing one loan paid off sooner, then she should focus the extra $200 on the auto loan first.  This will allow her to pay off the auto loan in just 3 years giving her a feeling of victory.

What do you think Nathaline… would you rather save $43 and take 53 weeks to pay off the first loan, or eat the $43 and have the first debt repaid in just 32 weeks?

What would you do?

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1 Paul

Don’t forget tax implications. The interest on the student loan may be partially tax deductable, making it more attractive to pay off the car faster.

2 Lance

Echo Paul’s comment, the tax implications of the student loans make paying the car off first the most attractive option.

I would also say that driving a paid for car after 3 years will boost the momentum of the student loan payments and might just be able to find even more money from the budget to pay down on the loan. Getting one monkey off the back can dramatically increase one’s motivation.

3 Matt Jabs

@Paul and Lance – thanks for bringing this up guys. Nathaline, depending on your tax bracket and the possibility of claiming student loan interest as a deduction, you may be better off repaying the student loan 2nd. Reason being, repaying the auto loan first will mean you’re paying more interest toward the student loan for longer, giving you a larger write off. How much this affects you depends on your AGI.

Another point to consider – student loan debt is essentially unsecured debt (backed by gov’t for lenders, but gov’t will ultimately call on student to repay, even to the point of wage garnishment and penalties) having no asset behind it, which could encourage some people to get rid of it ASAP. You can always sell the car (asset) to repay the auto loan… but you cannot sell your education to repay the student loan.

Also, if it ever came to this… student loan debt cannot be discharged via bankruptcy, auto loan debt can.

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