Saturday, September 22, 2007

Student Loan – Repayment Theory and Practice

Inventory your loan obligations - The Key First Step
• If you want to control your student loans rather than have them control you, the first step to financial freedom is the Student Loan Inventory. Between the GSL’s, Stafford’s, subsidized, and un-subsidized, losing track of the amounts and terms of each loan is easy to do.
• Subsidized Loans: Once you have your loans organized, you need to decide if consolidation is a good idea. For most people, I think it is. Unless rates are high, consolidation allows you to “fix” your obligation for whatever payment period you select. In my case, I was able to consolidate my loans at 4% with a 25 year payment plan.
• Un-Subsidized Loans: Although you may borrow money each year from the same lender, most lenders treat each “year” as a separate loan. You need to organize these by size and by interest rate. Although the lender may treat multiple loans as one loan for billing purposes, the credit rating agencies do not.

What are your payment options?
• Unless they increase your interest rate for allowing a longer repayment schedule, I recommend selecting the “longest” fixed payment plan available. By doing so, you free up cash flow for higher cost loans. In addition, the required payment will show up on your credit report. For FICO purposes, smaller = better.
• After you minimize your required payment, maximize your actual payment within your budget realities. Extra principle payments dramatically reduce your interest expense in the long run.

How to pay off loans early!!
• If you want to pay an extra $200 per month to reduce the value of your loans, how should you do it?
• Obviously, paying off the highest interest loans would be the smart move. In the example below, you want to pay: $200 to the consolidated loan, $70 to the big variable loan, and $230 to the smaller variable loan. Once the small loan is paid off, you can redirect the money to the next smaller loan. (The Debt Reduction Snowball)
• Unfortunately, lenders can make it difficult by allocating payments in ways not helpful to your plans. They will send you a payment slip with a combined minimum monthly payment and any extra money will be allocated to the ALL the loans. (Foiling the Snowball)
• To prevent this, you must give the lender detailed instructions to allocate the entire overpayment to the smaller loan. Inevitably, they will fail to follow directions and you will need to call to correct allocations.

Sample Student Loans for Discussion Purposes:
• GSL total loans: $30,000 at 5.5% rate (fixed) ($200 payment)
• Access Loan A: 10,000 at 8% rate (variable) ($70 payment)
• Access Loan B: 5,000 at 8% rate (variable) ($30 payment)


Minimum Wage said...

The theory was flawed because it didn't take into account borrowers who end up with minimum wage jobs.

Finance Guy said...

The theory assumes someone has sufficient income to pay back the loans and would like to do so in an efficient manner.

If someone takes out significant student loans and ends up with minimum wage job, the only way to pay off the loans is to increase income.