To pay off a student loan, should I save up a lump sum payoff payment or pay extra each month?

Question

I am a new college graduate with a student loan of $17k at 6.8% interest. The monthly minimum payment due is $193. I have been paying the minimum amount, and then taking that same amount and placing it into a savings account.

My original idea was to keep paying the minimum amount, and then saving the same amount until the total amount in the savings account was equal to the amount left on the loan. When the two amounts are equal I plan on paying off the entire amount. Is this a bad plan?

I am currently in the position to be paying more than the minimum, but I am trying to establish a nice lump sum in the bank for myself.

Thank you, I really appreciate any help/guidance with this.

Answer 1

As a new graduate, aside from the fact that you seem to have the extra $193/mo to pay more towards your loan, we don't know anything else.

I wrote a lengthy article on this in response to a friend who had a loan, but was also pondering a home purchase in the future. Student Loans and Your First Mortgage discusses the math behind one's ability to put a downpayment on a house vs having that monthly cash to pay towards the mortgage. In your case, the question is whether, in 5 years, the $8500 would be best spent as a home down payment or to pay off the 6.8% loan.

If you specifically had plans toward home ownership, the timing of that plan would affect my answer here, as I discuss in the article.

The right answer to your question can only come by knowing far more of your personal situation.

• Does your employer offer a matched 401(k) (or other matched retirement account if you are not in the US), and are you depositing the full amount to capture that match? It makes little sense to set aside funds to pay off a 6.8% loan if you are leaving a 50 or 100% match on the table.
• Do you have any other high interest debt? 18% card takes priority over this loan.
• What is the nature of your current savings and rate of savings? An emergency fund or funds that would take care of unexpected expenses, including bridging the gap during a time of unemployment is an important first step for the new grad. Start by hitting the first $1000, $2000, etc. But ultimately, you want X months worth of expenses to have a true safety net.

Meanwhile, the plan comes at a cost. Your plan will get rid of the loan in about 5 years, but if you simply double up the payments, advising the servicing company to apply the extra to principal, it would drop to just a couple month over over 4. As you read more about personal finance, you'll find a lot of different views. Some people are fixated on having zero debt, others will focus on liquidity. In the end, you need to understand each approach and decide what's right for you.

Answer 2

If the savings rate is the same as the loan rate, mathematically it doesn't make any difference whether you pay down the loan more and save less or vice versa.

However, if the loan rate is higher than the savings rate it's better to pay it down as fast as possible.

The chart below compares paying down the loan and saving equally (the gradual scenario), versus paying down the loan quickly at 2 x $193 and then saving 2 x $193. The savings rate, for illustration, is 2%.

Paying quickly pays down the loan completely by month 51. On the other hand, in the gradual scheme the loan can't be paid down (with the savings) until month 54, which then leaves 3 months less for saving. In conclusion, it's better to pay down the higher rate loan first. Practically speaking, it may be useful to have some savings available.

Answer 3

If you pay extra now you will pay less in interest over the life of the loan. Unless your savings account has a higher interest rate than the loan's rate you are not saving anything.

That being said, you may have a greater need for savings due to other things (e.g. you might need a emergency fund). But if you are only saving for the loan: compare the rates to see if it is worth it.

Answer 4

There are a few ways you can go about paying this off quickly (and safely):

You could start paying $386 monthly (ie, double what you're paying now). You'll pay less interest in the long run because they can only charge you for the amount outstanding. Remember, 6.8% of $12k is more than 6.8% of $6k.

However, your plan sounds more sensible. Say you get to $6k paid off and $6k saved, you're able to pay off what's left and that's almost $200 a month you'll have extra. Although what I like about this is - if you become ill, lose your job, or whatever, then you're still able make the $193 payments, PLUS you'll have money saved for day-to-day expenses (food, water, gas, electricity, etc.) long enough to see yourself through.

PS. They may charge you a settlement fee because if you pay early then they miss out on money... but check your contract with them first.

Hope this helps!

Answer 5

As someone in the very same position as you here is what I suggest:

Have $1,000 for each possible large expense you currently have. For example, house, car, pregnant wife, etc. As someone who only has a car (living at home still) I only have $1,000 in my eFund (emergency fund).

The ABSOLUTE rest of my money goes to paying off the loans as soon as possible. I mean ever single dollar. There is no point for investing unless you have a really good return on investment. I am not too sure how common returns of 6.8% are, but that seems above average. If in fact you're just stashing it in a bank account at ~1%, you're doing it wrong.

Getting out of debt is not only just about the financial benefits but the emotional benefits too. It feels really nice to not owe anybody anything.

Good luck man!

P.S. Try using a tracker like ReadytoZero to show how much you're losing a day by remaining in debt. This will better help you understand if your investments are making you money or losing your money.

Answer 6

The interest accrues daily based on the amount you owe. The less you owe the less the daily interest accrual. The faster you pay it off the less you pay in the lifetime of the loan. You are losing money if you bank money rather than applying it to the loan immediately. Since student loans cannot be declared in bankruptcy and interest rates cannot be refinanced, or are nonnegotiable, then you should consider your student loan a priority in case your employment/income runs into problems.

Answer 7

Just one more thing to consider: a friend of mine had some student loan debt left over from graduate school. Years later, through his employer, he was able to apply for and receive a grant that paid off the remainder of his student loan. It was literally free money, and a significant amount, too.

The windfall was a little bittersweet for him because he had been making extra payments over the years. The cap on the grant was something like $50k and he wasn't able to use all of it because he had been aggressive in paying it down. (Still, free money is free money.)

Sure, this is a unique situation, but grants happen.

Answer 8

Simply, you should put your money into whatever has the higher interest rate, savings or repayment of debt.

Let's say at the beginning of month A you put $1000 into each account.

In the case of the savings, at the end of month A you will have $1001.6 ($1000 + 1000 x 2% annual interest / 12)

In the case of a loan, at the end of month A you will have $1005.7. ($17000 plus 6.8 interest for one month is 17096.3. On $16000, the new value is 16090.6.

The difference between these is $1005.7.

5.7 / 1.6 = 3.56

Therefore, using your money to repay your loan nets you a return about 3.5 times greater.