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Reader Question: Big Student Loans

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One reader sent me an e-mail about his student loans.  He asks:

“I’ve had bad financial education in the past and now trying to fix all of these errors which I’ve made. Currently I have 4 loans from Sallie Mae which are total to $30000. Two of these loans have APR of 7.75%, one loan has 9.25% and one has 10.25%. This is quite ridiculous in my opinion, and I need some advice on how to fix it. What would you suggest?”

Loan 1: $4,988.61, 10.25%, $57.30 per month

Loan 2: $8,351.01, 9.25%, $90.85 per month

Loan 3: $11,878.93, 7.75%, $118.82 per month

Loan 4: $6,730.09, 7.75%, $67.32 per month

Total: $31,948.64 owed, $334.29 monthly payments

Option 1: The Debt Snowball

The debt snowball is the most popular debt repayment method around.  In the debt snowball, make your minimum payment on every loan to maintain a good credit score.  Any extra cash at the end of the month should go to the highest interest loan to pay it off as quickly as possible.  In this case, an extra couple hundred dollars each month could mean paying off the most expensive loan years sooner than the minimum payment alone. 

The loan balance does not matter in the debt snowball.  The 10.25% loan is the smallest in dollars owed and payments, but each dollar costs more than the other loans.

If you were paying the minimum plus about $200 per month, you are putting $257 into Loan 1 per month.  Once it is paid, put that $257 plus $90.85 per month into Loan 2 as you are already used to living without that $257 per month.  Paying $348 per month into Loan 2 will increase the payoff speed greatly, as the extra $200 did in Loan 1.  After Loan 2 is paid off, put the extra $348 per month into Loan 3 or Loan 4 (it doesn’t matter which, they have the same interest rate) until they are all paid off.

Option 2: Refinance

You are allowed to refinance student loans once over their lifetime.  If you have not done that yet, it might save you a bunch of money.  The current federal subsidized Stafford loan rate is 6.8%.  You can only take a Stafford loan if you qualify for financial aid after filling out the FAFSA.  At this point, assuming you are out of school, you probably can’t get 6.8%.  You can probably beat 10.25% and 9.25% though.  Do a little shopping around and try to do a debt consolidation refinance to lower your interest rate.

Do not just consolidate for the sake of it.  Consolidating generally makes your payoff period longer and raises your monthly payment for the life of the loan unlike with the snowball.

Option 3: Collateralized Refinance

If you have a mortgage or other valuable asset that can be used as loan collateral, you can refinance the student debt as a secondary lien on that asset, or a mortgage loan if the asset is already paid for.  This is the most cost effective method, but it has risks.

The best part of this method is that you will surely get a lower interest rate.  If you use a car as collateral, you may be able to get a loan rate around 5%.  However, your car has to be worth more than you consolidate.  If you own a car worth more than $13,000 outright, I would seriously consider consolidating Loan 1 and Loan 2.  If you own a house that has $30,000 in untapped equity, you can refinance the entire amount as a second mortgage or wrap up the old mortgage and student loans into one big mortgage payment.  There are fees and costs, but it could save you money in the long run.

The biggest risk to a collateralized refinance is that you are putting your asset on the line.  If you stop paying the loans, the bank can take the car or house (or boat, etc).  Think seriously about your ability to pay before taking this step.  You have to pay either way, in the long run, so it could be a good idea to save money by refinancing with collateral.

The Bottom Line:

Each person’s situation is different.  Anyone can do a debt snowball, so it is the logical best option for the average person.  If you can, doing a student loan refinance can save you money on interest but only works if you have a bank, or the Department of Education, that is willing to work with you.  If you are far enough in life that you have a valuable asset, you can save interest costs but have to risk an asset for that savings.

Now it is time for the readers to chime in:  Would you rather take option 1, option 2, or option 3?  Did I miss something completely?  Please help our student loan debtor make the best decisions to get out of debt.

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