One of my Yakezie friends Fiscal Phoenix got some advice from a financial planner about paying off debt. The choice was between paying down student loans and paying down credit cards. The credit cards had a lower average balance and a higher average interest rate than the student loans. Given these pieces of information, it seems like it would make more sense to pay down the credit cards first rather than the student loans. Right?
Her financial planner gave her the opposite advice: pay down the student loans, which had a higher balance and a lower interest rate. The planner's reasoning was that credit card debt can be discharged in a bankruptcy, while student loan debt cannot.
Student loans: A great deal for everyone except the student
Who in their right mind would loan someone tens or even hundreds of thousands of dollars at low interest rates for someone to advance their education? Banks do it with mortgages and car loans because there is collateral: they can take your house / car back if you don't pay. Not so with an education. The diploma is worthless to them.
They write student loans because some kinds are guaranteed by the government. Then, why would the government do this? Well, the bankruptcy rules (Section 523(a)(8)) make many student loans non-dischargeable in bankruptcy unless undue hardship can be demonstrated. This means that the student loans stick around longer than other debts, even through they've bankruptcy.
It's a virtuous circle for lenders and educational institutions: lenders can lend with little fear of getting stiffed, educational institutions can ratchet fees several percent each year regardless of inflation, and the government backs it all. It's bad for students: they're paying (and borrowing) more and more for degrees that are worth less and less, and the student loan burden sucks the life out of their finances for years.
Why plan to fail?
Even with the risk of having the student loans stick around bankruptcy, paying down the credit cards first is better for a number of reasons:
- Paying down the lower-balance debts first gives a quicker victory. The payment is gone after the debt is paid off, and the money is freed up to attack the other debts.
- Paying down the higher-interest-rate debts first saves interest. The higher the interest rate, the more money saved by paying the balance off faster.
- The credit card minimum payment decreases, even with a remaining balance. Student loans are installment loans — there's a constant minimum payment throughout the life of the loan. Paying down this kind of loan doesn't reduce the monthly payment; it only reduces how long you have to make those minimum monthly payments. Credit card minimum payments, however, are usually some low minimum amount, unless the balance exceeds a certain amount, at which it become a percentage of the balance due. So if the minimum credit card payment is, say, 4% of the balance due, then paying down a $10,000 balance to $8,000 reduces the minimum payment from $400 to $320. This gives some extra breathing room in case something bad happens.
In short, I'd pay down the credit cards first in this case. 🙂
I completely agree – always pay down the higher interest loans first. My student loans have always had the higher balance (started out in the $55k range), but had a ridiculously low interest rate thanks to now-retired consolidation rules – 1.75%!! If I could refinance my house under the terms of my student loan, I definitely would.
I don’t have this problem but if I did I would pay the high first. Or consolidate.
Very convincing reasons. I usually pay in proportion to subsisting balances, not minding about interest rate comparisons. Thanks for the advice.
Paying down credit cards can also make your credit rating increase, whereas paying extra on installment loans doesn’t give you the same benefit.
I’d pay down the higher rates as well. Yes, student loans can be like cockroaches, they don’t go away even if you take a scorched earth approach to your finances. However, higher interest rates can create real problems if left to add to your credit card balances. Get rid of the debt that accumulates, meaning the higher rate credit cards.
I think it ultimately comes down to each person individually and what motivates you to pay off your debt quickly. If you are motivated by how much interest you are paying, hit the higher interest rate debt first. If you are motivated by knocking out the debts one by one, hit the smallest balance first.