Who misses the good old college days? From late-night study sessions at the library to student tailgates to the many fun memories in between. Although those years are now behind us, debt has a funny way of tagging along. Lucky for many, we receive a persistent reminder each month of just how much those memories cost us via our student loan bill.
All joking aside, student debt can be very stressful for individuals post-graduation. Suddenly, bills start to pile up from cars, homes, rent, utilities, and in many cases, a mortgage-sized student loan. It is very important for those with student debt to take every opportunity to pay it down when they can. We covered compounding interest in the previous article. As illustrated previously, it can add up quickly for those just making minimum payments on their outstanding debt.
With that said, what is the best approach to paying down that pesky student loan? As I mentioned, we often accumulate different loans with various interest rates and associated values. This is where the great debate of the snowball versus the avalanche approach commences.
First, let’s outline how each of these approaches works.
Snowball involves paying down the smallest outstanding loan value first to eliminate the number of loans that you have quicker.
Example:
Loan | Loan A | Loan B | Loan C |
Value | $12,500 | $5,000 | $36,000 |
Interest Rate | 6.0% | 3.0% | 7.5% |
In this example, the debtholder would pay down the debt in the following order:
Avalanche is the method where the debtholder elects to pay down the loans in order of interest rate, tackling the highest interest rate loan first and leaving the smaller interest rate loans until the end.
Example:
Loan | Loan A | Loan B | Loan C |
Value | $12,500 | $5,000 | $36,000 |
Interest Rate | 6.0% | 3.0% | 7.5% |
In this same example, the debtholder would pay down the debt in the following order:
So which is the best method?
Well, those who like to see the progression and instant gratification may think that the snowball method wins the race. The reason being is you will see the number of loans you have outstanding dwindle down much faster.
But that sounds too easy, right? Yes!
Let’s dig into the numbers to see which method reduces the total interest paid over the life of the debt.
Snowball | Avalanche | |
Years to Payoff | 16.5 | 15 |
Total Interest Paid | $45,108.88 | $36,464.41 |
As you can see above, when leveraging the avalanche method, individuals pay off the debt in this example over a year and a half earlier and keep an extra $8,644.46 in their pocket!
There is no discrepancy. It makes sense 100% of the time to work through your student loan debt by paying down the loans with the largest interest first, regardless of the size of each loan. While it may feel like you aren’t getting anywhere for a while, especially if that loan happens to be the largest in size, it will save you both time and money.
This is where financial literacy pays off quite literally.
I hope that today’s blog has helped sharpe-n your knowledge of the investment landscape. If you have any topic suggestions or have further questions, please reach out to mkowalski@hightoweradvisors.com.
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