Student Loans: Am I Doing the Avalanche Method Right?

[ReadySetMillionaire]

I graduated with about $150,000 in student loan debt (had to pay undergrad, law school, and then loans capitalized as I was looking for a job...but it's time to look forward and get these paid off).

I am enrolled in IBR, but my minimum payment is extremely low--$78.00 (based on last year's extremely minimal income). Thus, I pretty much have complete freedom to pay towards any loan I want.

The counter to this, however, is that my minimum payments on each loan are extremely low. For instance, one $23,000 loan at 6.55% interest has a minimum payment of $11.00. That means interest would balloon substantially if I didn't pay more than the minimum payment each month.

Thus, for right now, I'm trying to cover the accruing interest on each loan each month, plus a little more, then throwing everything at my highest interest rate loan.

Here is the loan/payment breakdown (can only afford $1,003 total):

1) Plus Loan: $7339.46 @ 6.16%; accrues $37.16 monthly interest; payment = $40.00

2) Plus Loan: $21,067.34 @ 6.16%; accrues $106.66 monthly interest; payment = $110.00

3) Ubsubsidized Stafford Loan: $21,899.47 @ 5.16%; accrues $92.88 monthly interest; payment = $100.00

4) Plus Loan: $27,481.16 @ 7.65%; accrues $172.79 monthly interest; payment = $385.00 (max leftover).

5) Unsubsidized Stafford Loan: $23,634.92 @ 6.55%; accrues $127.24 monthly interest; payment = $140.00

6) Plus Loan: $8,395.07 @ 7.65%; accrues $52.79 monthly interest; payment = $60.00

7) Unsubsidized Stafford Loan: $14,676.24 @ 6.55%; accrues $79.01 monthly interest; payment = $90.00

8) Subsidized Stafford Loan: $8,542.60 @ 6.55%; accrues $45.90 monthly interest; payment = $2.00*

*When enrolled in IBR, the government forgives any accrued interest on subsidized loans; thus, just making some minimum payments.

9) Subsidized Stafford Loan: $2,656.41 @ 6.55%; accrues $14.40 monthly interest; payment = $1.00.

10) Unsubsidized Stafford Loan: $5,677.74 @ 5.35%; accrues $24.97 monthly interest; payment = $30.00

11) Unsubsidized Stafford Loan: $4,755.51 @ 6.55%; accrues $25.60 monthly interest; payment = $30.00

12) Unsubsidized Stafford Loan: $2,289.73 @ 6.55%; accrues $12.30 monthly interest; payment = $15.00

TOTAL PAID = $1003.00.

Am I doing this right? Or should I be cutting back even more on the loans that aren't at 7.65% (for instance, paying 50% of accruing interest instead of 100% and more)?

[plainjane]

I think it makes sense to pay more than the minimum on the items which are accruing interest faster than the IBR would pay and wouldn't be forgiven under the plan.

The only tweak I'd suggest is to your two 7.65 accounts.
4) Plus Loan: $27,481.16 @ 7.65%; accrues $172.79 monthly interest; payment = $385.00 (max leftover).
6) Plus Loan: $8,395.07 @ 7.65%; accrues $52.79 monthly interest; payment = $60.00

And paying off the smaller one first, so you get an earlier win.  Something like:
4) Plus Loan: $27,481.16 @ 7.65%; accrues $172.79 monthly interest; payment = $175.00.
6) Plus Loan: $8,395.07 @ 7.65%; accrues $52.79 monthly interest; payment = $280.00  (max leftover)

[ZiziPB]

^ This.  Completely agree with plainjane.

BTW, I said this on another thread but I'll say it again.  I applaud your decision to pay off your loans and not count on some loan forgiveness program.  I think you will do well in life with that type of attitude!  Best of luck!

[ReadySetMillionaire]

I posted this identical post on Reddit (/r/personalfinance), and the consensus there seems to be that I should be paying the absolute minimum on each loan and putting the rest towards my highest interest rate loans.

I haven't been able to run the numbers, but I don't see how this is mathematically sound.

Take this loan for example: Ubsubsidized Stafford Loan: $21,899.47 @ 5.16%; accrues $92.88 monthly interest.

By following the avalanche method, I won't start paying towards this loan for 7-10 years. By then, however, it will have accrued almost $8-10k in interest.

The folks on /r/personalfinance, though, insist that paying off the higher interest rate loans more than makes up for letting the interest accrue like this.

So who's right? Me for wanting to stay on top of the interest, or the folks on /r/personalfinance?

[ReadySetMillionaire]

And I think I'm starting to get their point.

By paying towards the interest each month (like I'm doing now), I'm effectively paying as much in interest as I would have if I had simply let the interest accrue. Thus, my money is better spent towards the higher interest rate loans.

Is my brain working correctly?

[slugline]

It should look mathematically sound if you, well, actually run the numbers.

[ioseftavi]

And I think I'm starting to get their point.

By paying towards the interest each month (like I'm doing now), I'm effectively paying as much in interest as I would have if I had simply let the interest accrue. Thus, my money is better spent towards the higher interest rate loans.

Is my brain working correctly?

Yes.  You are. 

My wife and I did this with her law school debt, which we just finished paying off last year.

It will feel weird not covering the interest on some of your loans and just paying the minimum.  But that's ok - you're not looking to cover the interest on each loan.  You're looking to pay the lowest overall amount of interest, across all the loans, over the life of all the loans.

The way to do this is to pay the minimum on all loans, except for the highest cost one.  You throw everything that remains at the highest cost loan.

So yes, all your loans that you paid the minimum on will go up - you didn't cover their monthly interest charges.  But for your MOST expensive loan, the most costly one you have, you will sharply reduce your principal. 

You will reduce the interest you owe across all loans by focusing your payments on the most costly loan.

[ZiziPB]

And I think I'm starting to get their point.

By paying towards the interest each month (like I'm doing now), I'm effectively paying as much in interest as I would have if I had simply let the interest accrue. Thus, my money is better spent towards the higher interest rate loans.

Is my brain working correctly?

Does the interest simply accrue or is it capitalized?  If it's simple accrual, then I think it may make more sense to to not pay it beyond the minimum payment required and funnel the money to the high interest loans.  If it is capitalized, then your method is the right one.

[ReadySetMillionaire]

And I think I'm starting to get their point.

By paying towards the interest each month (like I'm doing now), I'm effectively paying as much in interest as I would have if I had simply let the interest accrue. Thus, my money is better spent towards the higher interest rate loans.

Is my brain working correctly?

Does the interest simply accrue or is it capitalized?  If it's simple accrual, then I think it may make more sense to to not pay it beyond the minimum payment required and funnel the money to the high interest loans.  If it is capitalized, then your method is the right one.

It accrues.

[ZiziPB]

In that case, I would just make the minimum payments on the lower interest loans and focus on the higher interest ones instead, as ioseftavi said.

[krishnamba]

Hey

I had a similar loan loads with similar interest rates. I was trying to find refinancing and was finally able to with a company called DRB.

I would first calculate your wacc on all the loans. Though I didn't get a great rate, it was about .5,(I wanted like 2-3 pct less) less than my wacc and consolidated all my loans.

I used it as a method to control my cash flow.

[Louisville]

All those loans - what an incredible pain in the ass. Isn't there a way to consolidate? Maybe even consolidate at a lower total interest rate?

[ReadySetMillionaire]

All those loans - what an incredible pain in the ass. Isn't there a way to consolidate? Maybe even consolidate at a lower total interest rate?

Yes, but from what I've read, consolidating simply averages the interest rates on my loans and is therefore more expensive than doing the avalanche method.

It certainly is a pain in the ass, though, which is why I set up my autopayments at the beginning of the month and then forget about them. Luckily my loan provider lets me do this online and it only takes about 15 minutes per month.

[ioseftavi]

All those loans - what an incredible pain in the ass. Isn't there a way to consolidate? Maybe even consolidate at a lower total interest rate?

Yes, but from what I've read, consolidating simply averages the interest rates on your loans and is therefore more expensive than doing the avalanche method.

Not quite true.  Consolidating loans will save you money if the new interest rate is lower than the previous weighted average interest rate.

Example:
Student loan A: $10,000 @ 8% interest
Student loan B: $18,000 @ 6% interest
Total: $28,000

Weighted average interest rate = Sum of ((Student loan balance / total balances) * student loan interest rate)

((10,000 / 28,000) x 0.08)
+
((18,000 / 28,000) x 0.06)

= 0.0286 + 0.0386

= 0.0672%

Weighted average interest rate is 6.72% in this example.

If our hypothetical student can consolidate all loans at less than 6.72%, (s)he will save money.

Consolidating only saves you money if it brings your weighted average interest rate down.  It will also save you a lot of hassle - as you've pointed out, there's a fair bit of pain in the assery dealing with 10 separate loans or whatever.

[ReadySetMillionaire]

All those loans - what an incredible pain in the ass. Isn't there a way to consolidate? Maybe even consolidate at a lower total interest rate?

Yes, but from what I've read, consolidating simply averages the interest rates on your loans and is therefore more expensive than doing the avalanche method.

Not quite true.  Consolidating loans will save you money if the new interest rate is lower than the previous weighted average interest rate.

Example:
Student loan A: $10,000 @ 8% interest
Student loan B: $18,000 @ 6% interest
Total: $28,000

Weighted average interest rate = Sum of ((Student loan balance / total balances) * student loan interest rate)

((10,000 / 28,000) x 0.08)
+
((18,000 / 28,000) x 0.06)

= 0.0286 + 0.0386

= 0.0672%

Weighted average interest rate is 6.72% in this example.

If our hypothetical student can consolidate all loans at less than 6.72%, (s)he will save money.

Consolidating only saves you money if it brings your weighted average interest rate down.  It will also save you a lot of hassle - as you've pointed out, there's a fair bit of pain in the assery dealing with 10 separate loans or whatever.

Thanks for the post.

Right now I'm sticking with my federal loan service provider so I can keep my IBR protection (and other protections that come with federal loans). Thus, my consolidation hypothetical was targeted towards a consolidation with my federal service loan provider.

I have, however, looked at private loan consolidation. The best rate I've seen is from Charter One (5.19%), but this is just an advertised rate.

Thus, I'm applying the avalanche method until I feel comfortable enough with my job security that I'll consolidate through a private lender. This ensures three things: (1) I keep my federal loan protection in case shit hits the fan; (2) I can build my credit over the next two years to ensure the lowest possible interest rate; and (3) if Congress passes legislation lowering the interest rate on consolidation, then I can take advantage of that (i.e., you can't go back to federal loans once you consolidate with a private lender).

It's kind of like a short term sacrifice that might enable big rewards later.