Those of you who read this sit probably have come to the conclusion that I advocate paying off your loans – credit cards, autos, student loans – as early as possible, and you’d be right. Here’s a demonstration of why:
This is a scenario I built using an actual loan of mine using the projection calculator for student loans at calculator.net. Below is the loan, on the timeline of my income-based repayment plan, and the interest rate it carried before Congress suspended interest rates on Federal Student Loans during COVID. (Direct Loans carry low interest rates than other Federal loans, which were about 6.2% before the interest rate holiday.)
Yikes! You end up paying $3,401.59 for the privilege of borrowing that $5,000! That feels kind of like robbery, but it’s a function of extending the timeline so far. Sometimes you don’t have a choice but to accept this kind of deal. But lets see what happens if I set myself a different goal: Paying off the loan in 5 years and accepting whatever payment it gives me:
To repay the $5,000 loan in 5 years, my actual goal once I graduate, I will have to pay $90.44 per month, assuming the interest rate goes back to what it was before the pandemic. That’s an extra $70.44. To put this in a bit of context, my cell phone bill is more than this extra payment, by about $10.
But look at the difference in the interest for one thing and the total payments for another.
- Interest on the first loan was $3,401.59, but reduced all the way down to $426.68 in the 5 year repayment plan. That’s $2,984.91 over the next 30 years that will stay in your pock rather than going to the loan company. Put another way, that’s ~$100/year that you’re not paying on interest during the next 30 years after the loan is paid off.
- But also look at the interest vs. the principal, or original amount borrowed, in the two scenarios! 40% of the outlay in the original 35 year payment plan is interest, but only 8% of the total outlay in the 5 year goal is. That seems like a much more reasonable distribution.
Now, this was an example with a small loan. These effects get bigger as the loans get bigger. Let me show you that with a mortgage priced out using the mortgage calculator available form calculator.net. For simple math, let’s start with a $200,000 house (not unreasonably in my area, but I live in NJ and housing is expensive year) with a 20% down payment, 30-year term (an industry standard), and 5% interest (actual rates right are lower, but again, simple numbers for simple math.). Here’s what it looks like:
We’d end taking a loan of $160,000 after our down payment is applied, and at 5% interest would pay just slightly less than $10,000 as much in interest as the price of the house! You might be able to buy a second house with that interest!! Now mortgages are for large amounts, so the interest outlays in pure dollar terms are of course going to be larger. But the percentage is the thing here, 48% of your spending is just paying the interest! That’s similar to the 40% of spending on our student loan. Long loan terms = lots of spending on interest.
There is another standard type of mortgage that is available from most lenders that shortens this window: the 15-year mortgage. In reality, mortgage rate are slightly different on 15-year loans the 30-year loans, usually a hair higher so the lender still gets some good money. It’s the same in this scenario for the sake of easy math an a straight comparison But you outright own your house 15 years earlier than in the first scenario, and that’s also a big deal! What does shortening the repayment term by 15 years do to our payment?
As you can see, our payment goes up by $436.36 compared to a 30-year mortgage. That might feel high if you’ve never owned or rented housing, but honestly, that’s about what I paid in rent back when I rented. Same down payment, same interest, $81,460.69 less paid in interest over the life of the loan. And it reduces our interest relative to the total to about ~30% of our spending. That feels high, but our total spending is less by that saved interest so it’s better than it looks. When you start dealing with numbers this size, there are going to be sizable amounts of interest no matter what, but lets not give the bank more than we have to, right? Oh, and those 15 next years you have with no mortgage payment, that saved money that you get by virtue of not having a mortgage in those years, that works out to about $5,430 per year for you to use however you want.
In both of these scenarios, we can see that speeding up our debt repayment by shortening our payoff window (either officially by taking a 15-year mortgage or unofficially by paying extra on a loan each month) saves us some serious money in the long-term, in the form of money freed from payments once the debt is gone that you would have otherwise spent in interest on the debt. This is why payoff strategies like Dave Ramsey’s Debt Snowball, or the similar Avalanche method work so well. It’s why I stress that even if it’s only $25 or $50 extra a month, pay off your debts as fast as you can so you can have a future of not having debt in front of you!