Help a Reader: Debt Snowball

Here's an email I recently received from a reader:

Here's my situation: I recently graduated from law school. I have three loans:

a) Federal student loan - $19,000 (interest 8.25%)
b) Provincial student loan - $6,000 (interest 8.25%)
c) Private student line of credit - $57,000 (interest 5.25%)

(These are the current balances - I've already paid down 10K this year).

Most of the advice about snowballing debt payments says to start with the highest interest or alternately the lowest balance. In either case this would mean starting with my government loans. But here's what's tripping me up - the interest I pay on my government loans is tax deductible, and there are reward programs in place whereby your debt will be reduced if you make 12 consecutive payments. I live frugally and I have about $2500 a month alloted for debt repayment. What are your thoughts?

Any suggestions?

Comments

[savvy]

I would pay them off in interest rate order and disregard the tax deduction. For one, we don't know the reader's income and the deduction is phased out over a certain income level. Also, for every dollar in interest that you pay, you get 25 cents off your taxes (assuming 25% tax bracket). Nevertheless, you're still out of 75 cents. Also, those incentive programs generally lower your interest rate by less than 1%, which still gives 7.25% for the federal loan vs 5.25% for the private loan.

With $2500/mo allotted, the reader can pay off loan B in a mere three months. Loan A can be paid off eight months after that.

[Zook]

First question...

What can you consolidate? Have you done that already? I would think 8.25% can be lowered a bit.

The private student line of credit...Can you deduct interest payments for this?

Not knowing the entire situation, I also think you would be wise to begin saving some money as well. I think folks develop good habits early and even if you take $100-$250 a month towards your retirement account or into a taxable account, the mental aspect of doing both at the same time is better, IMHO for some folks, than just paying everything towards debt. Yeah, it might take a few extra months, but the habits you develop are worth it in the long run...

I would tackle them in the order B-A-C. Ignore the tax deduction, and if I understand correctly, you should still be making minimum payments on all three, so you will still get the reward for paying 12 months consecutively. Apply whatever is left after the minimums to the debts in that order.

[Zook]

Ignore a tax deduction on a $57K school loan at 5.25%? Huh.

Tackle the the two at 8.25% and see if you can consolidate them. You can lock in 2.99% for the life of the balance transfer on many credit cards right now. You may have to wait to the loan is lower, depending on income and your FICO scores.

Continue to make minimum payments towards 'C' until you can tackle that one by itself.

[Nicholas Paldino]

It's always better to pay off the debts with the highest interest rate first. Assuming that the student loans have a term of 10 years (that's what I remember the term on mine being, the person posting the question might want to post that information), $1,500 would be saved paying off extra principal on the 8.25% loan over the 5.25% loan first.

Reading what Zook said, it would be a good idea to pay off the 8.25% loan first with extra principal payments. Once that is paid off, however, I would take that money that would be applied to debt and apply it to an investment account of some kind. It should be pretty easy to beat 5.25% on your own, or with the help of a financial advisor.

I've emailed the amortization sheets to the blog so he can double-check the calculations, if he wishes.

My guess is, the deduction you are going to get for paying the interest isn't going to be worth it in the long run. Based on the balances and interest rates, you've got the perfect payoff situation going on. Pay off those lower balance/higher interest loans first and tackle the larger one later.

Assume you pay $500 interest for a year for one loan. If you can pay it off in say 3 months and only pay about $100 in interest. That is much better than paying the $500 for the tax deduction of somewhere around $125. $325 or $100...hmmmm.

Go back and do some math on these numbers. There are plenty of financial calculators out there to help.

[Ross]

David Bach says to DOLP your debt out of existence. (DOLP = Dead on last payment)

To find your DOLP numbers for each debt, take your balance and divide it by your minimum monthly payment.

Start with the smallest DOLP number and put every spare $ you have into paying it down, while making minimum payments on the rest. Once that debt is dead, continue the snowball.

[Zook]

I didn't mean to suggest the student loan deduction is a life saver, but if the $57K is a qualifying loan, that is a pretty nice perk to have. I didn't suggest a strategy with that, basically stating a fact and looking for clarification. Ignore a tax deduction is what you stated, not me.

My first comment was basically asking if the $57K has interest payment deductions. Nothing more or less.

[reader that needs help]

thanks for the comments - some people have asked for clarification so here it is:

the 57K loan does not qualify for income tax credits. only the $19,5K and $6K loans do, at a rate of 26% for every dollar spent. and yes, my amortization period on these government loans is 10 years.

[Zook]

Good information. Thanks for the clarification.

Have you looked into the one shot deal of consolidating the student loans that qualify?

[Ken]

B-A-C

As a lawyer you will start to phase out the deduction.

[Evan]

Also a recent law school grad (about 2 years out) Congrats! Everyone always told me my student loans were deductible, but guess what the deduction phases out at $75K/yr.

Take that into consideration!

[zOrville]

Another possible way to look at it: If something unforseen happens (serious illness, accident, etc.) it is likely much easier to defer government loans than a private loan - I would personally get rid of the private on first. Furthermore, 5.25% of $57K is more interest (about $3000 per year first year verses $2000 for others) in actual dollars per year. Rate lower but principle much higher is more actual money paid out!

[Trent D.]

The other comments have covered any ideas I may have had - but I just wanted to say "congratulations" on attacking your debt so fiercely. I encourage you to stick with it. As Dave Ramsey is fond of saying "you're living like no one else, so that later you can live like no one else."

It will definitely pay off, and you'll soon reap the rewards of all that money you saved on interest!

[kitty]

I think zOrville has a point. If an emergency happens, payments on a smaller loan is easier to come up with. Another thing to consider is if 5.25% interest fixed or can go up at any moment. If the interest can go up, the reader may pay off 8.25% fixed, defferable, tax-deductible loan and then get stuck with huge payments a high interest private loan.

[JK]

Are you in the US or Canada? If you are in Canada, you might detail your interest deduction for the rest of us, ie - what is your tax rate (40-45%?), is there a phase out, is consolidation an option?

Here's another tip for you: 99% of the advice that is out there does not apply to you. That advice (generally) applies to those with incomes substantially lower than yours. If you can afford to pay $2500 on your loans, I would look into your investment options.

While it may feel nice to be debt free (I personally don't know, or care to know, what that feels like) at your age, cash is more important than being debt free. Once you make a loan payment (car, school, mortgage) that money is gone forever. While it does reduce your debt and hence your interest paid, it will not multiply as it will when saved/invested.

Essentially you have $82,000 in debt at an average rate of 6.16% for a payment of roughly $920/mo. This would leave $1580 as discretionary. If this discretionary amount was invested at 6.16% for 10 years, it would be worth $261,190. Not bad considering principal and interest on the student loans for 10 years will amount to just over $110K.

I would look to consolidate if that is an option (not to a credit card as someone suggested) for a longer term. Longer term=lower payment=more cash now. For a 30 year term the payment is $500, the total of all payments over 30 years is $180K, and your investment account grows to over $2 mil at 6.16%.

This is what my wife and I are doing. By freeing up extra cash every month, we are buying and fixing a house, as well as investing substantially.

Debt is not the enemy! Mismanagement of debt is the enemy, and to me that means prepaying long-term debt!

Just my thoughts...

[dogatemyfinances]

If you are a lawyer now, hopefully you make too much to deduct your student loan interest (it's very low, like 60K income). I would hope a lawyer would know that.

[The Happy Rock]

I would put in a vote for BAC too. The interest deduction would be 25% of 2000 if you salary doesn't already phase it out. The reason I think BAC is generally the right idea is that emotionally, destroying debt self perpetuation and motivating. The feeling of getting payment in full letters really spurs you on to get more intense.

With your salary and the desire to attack your debt early, I have no doubt that you are be in great financial shape in a few years.

@z0rville - I am not sure that it matters that the big debt accrues more interest. Paying off 2500 of an 8.25% debt saves your more than paying 2500 on a 5.25% debt.

[laketrout]

reader that needs help: You may want to clarify for readers that you are in Canada so they'll stop berating you for not using the tax deduction for your private loan ...which can not do ...because you're in Canada ...and the tax laws are different.

[Rick]

JK has a few good thoughts, but there's a problem with his analysis. If you pay $2500 towards the debt every month, it will take you less than 10 years to pay it off. In fact, if you invest it at 6.16% vs. paying off a loan at 6.16%, you'll break perfectly even either way.

However, another point he made is certainly true. If you pay off the loan, the money is immediately gone. However, if you save/invest instead, and later on something happens and you lose your job, you can always use the money to carry you through the hard times while making minimum payments on the loans.

And as others have stated, I would definitely ignore the tax deduction, because the deduction is phased out at a relatively low amount (starting at somewhere around $63K), so if you have $2500/month to throw at your debt, you're probably making more than $63K / year.

Personally, I would pay off loans A and B, since they're at a high rate. Then try to get the rate on C lowered, perhaps through a lifetime balance transfer, or through a mortgage loan on your house (maybe a HELOC or something). Alternatively, there are various promos on credit cards you can get for 0% for 12 months or so. Then take the money and invest it instead. All you have to do is beat 5.25%, which should generally be pretty easy to do.

[rymon]

You said you live frugally and yet seem to have sufficient income that you be able to take advantage of the tax-deductible feature, I suggest you pay as little as possible on A & B just enough for you to enjoy the 12 consecutive month reward program and enjoy the tax-deductible (because it's as good as 0% interest). The rest of the 2500 pay on C. If your income bracket is low enough you can't enjoy the tax-deductible feature, then ignore the feature and pay highest interest first. But if your a lawyer now, and command a comparable Prof.Fee, then you should be able to enjoy the feature.

ey.. wait.

But if tax-deductible 26% of every dollar, interest is 6.11%. How much is the reward on the program? Pay A & B first. Interest on C is lower even without the feature.

Then again, your a lawyer. You should know better.

[MrsMoney]

Personally I would pay on the ones with the highest interest rate for peace of mind. I would also calculate the tax advantage and see if it's really worth it.

[Mariem]

I'll always vote for ditching the private loans before the federally backed ones. Mostly because if you fall on hard times the federal loans permit you to defer, disappear if you dies, and some other perks that private loans don't allow. I view private loans much like credit card debt - unsecured and dangerous.

[kitty]

"I view private loans much like credit card debt - unsecured and dangerous. "
Actually, if we believe Suze Orman, private loans are worse - credit card debt can be dismissed in bankrupcy, but not private student loans, and many of them are at variable rate. Now I only watch her for entertainment, so I don't look at everything she says as gospel; but as I have no personal experience with private student loans I figure I'd mention it.

More importantly, the post doesn't say if 5.25% a fixed rate or variable rate. I find it a bit strange that a private loan is at lower rate than the government one. It is mentioned in the post that this was a credit line. Arent't those usually variable? Are we comparing apples and apples or apples and oranges. Can 5.25% become 10%?

[Brian]

If you keep up with the $2,500 per month debt payment, you should have it all gone in less than 4 years, so it might not be that big of a help in deducting interest for that short of a period. Personally, I would see if I could get the interest rate reduced on A, pay off B first since it's so small and the benefits of keeping it wouldn't be enough. After B is gone work on C, which won't take more than 2.5 years tops. That way you get the tax deductions and debt reduction benefits.

[reader that needs help]

more clarification:

- yes, i am in canada
- all of the loans are variable, including my government loans

thank you so much for all the helpful comments. you've given me a lot to think about.

(including the snarky comments about how a "lawyer should know better" - but i guess i have a lifetime of that ahead of me. :))

[Steve]

I have a question for the person who posted.What student loans have the 12 consecutive payment reward reduction? I am from Canada too and my wife has student loans.So I am interested in who offers this program.

[reader that needs help]

hi steve:

some provinces have a debt reduction award - you need to check with the provincial authority that granted the loan.

[JK]

@Rick -

While it may seem like 6.16% is 6.16% whether you are earning or paying, I can perfectly assure you that is not the case.

Here's why:
Your loan balance is always DECREASING, so you are paying interest on a continually smaller amount each month. Your savings is earning on a gradually INCREASING amount each month.

Do the math and tell me I'm wrong...

[No Debt Plan]

1. Build up an emergency fund (whatever you are comfortable with -- $1,000, 3-6 months, whatever.)
2. Pay off B in 3 months or less.
3. Pay off A.
4. Pay off C.

I would focus solely on cash flow and going in this order steadily increases your cash flow. But I would have that emergency fund first before moving onto paying extra on the loans.

[thomas]

consolidate or BT that crap. The small amount of tax deduction you get on those loans doesn't even come close to what you are paying.

[David]

Forget the tax deduction. I never understood why someone would want to pay extra just to save a fraction of that in tax.

If it were me, here is what I would do:
Because I live by O'toole's law which says that Murphy was an optimist, save at least 2 months minimum of expenses as an emergency fund. It would really suck if you had to incur more debt to pay repairs on the auto just so you can get to work.

Pay the minimums on all 3 and put the extra into the smallest remaining balance. As you pay them off you will get a rush of excitement that will carry you forward and keep you on track to pay off your debts.

[David]

Forget the tax deduction. I never understood why someone would want to pay extra just to save a fraction of that in tax.

If it were me, here is what I would do:
Because I live by O'toole's law which says that Murphy was an optimist, save at least 2 months minimum of expenses as an emergency fund. It would really suck if you had to incur more debt to pay repairs on the auto just so you can get to work.

Pay the minimums on all 3 and put the extra into the smallest remaining balance. As you pay them off you will get a rush of excitement that will carry you forward and keep you on track to pay off your debts.

[Nicole]

If your federal interest rate is that high, i would imagine you have not consolidated - i would find out what the interest rate is for consolidated loans and, assuming it is lower than your current rate, lock it in.

Once you've done that, I would pay off the highest interest loans off first and work my way down.

On a side note, if you are qualifying for a tax deduction on your federal loan interest, perhaps you should try to find a higher paying job. Most people I know who graduated from law school are being paid too much to qualify for a tax deduction (a good problem to have).

[Nicole]

oops - didn't read all the comments first, so did not know questioner is in Canada. Might want to edit the original post to say so, because people don't always have time to plow through all the comments before responding (just a suggestion).

I have no idea what the laws are in Canada regarding consolidation and tax deductions, so I can't really answer the question, other than to say I would pay off the highest interest rate first.