What To Do About Student Loan Interest Capitalization

If you're currently in college and have student loans, you may have recently received one or more quarterly interest statements from Direct Loans. Current students are given the option to delay their monthly payments until they're finished with school, though interest may have already began to accrue. This accrued and unpaid interest is what this form details.

Statements will show a current balance along with a figure for Total Unpaid Interest. Though this is not an actual bill, it looks a lot like one because of the clear bold figure indicating how much you might want to pay and the inclusion of a pre-addressed envelope and remittance form. So should you pay it?

The short answer: Yes, you should probably pay it.

Unless you absolutely cannot afford it or if you have debt with a considerably higher interest rate than the student loan, I'd like to see you pay all of the Unpaid Interest. Basically, unless you're dead broke, have high-interest credit card balances, or if you've got a loan shark chasing after you, grab your purse and start writing a check to the U.S. Department of Education.

Here's why: If you make a payment toward this loan -- especially if it's only for the listed amount on the form -- you're going to decrease your tax liability for the current year. If you're in the 25% tax bracket and you have $100 in unpaid interest, a payment of $100 will increase the size of your refund by $25 even if you're using the standard deduction. This $25 far outweighs how much you would save in interest by sending that same $100 to a loan with a slightly higher interest rate that is not tax deductible.

My wife just received a quarterly interest statement for her student loans. Because she's enrolled in grad school, no payment is due at this time. Currently, the interest rate on her student loans is about 1% less than the rate on our auto loan. So I considered letting it ride on the student loan interest and making a larger payment this month on our auto loan. But because the interest on an auto loan is not tax deductible, even with its higher rate it makes sense to pay the Total Unpaid Interest on the tax-deductible student loan.

But keep this in mind: If you have debt with a higher interest rate than your student loans -- like an auto loan -- only pay the Total Unpaid Interest on your student loan, and never more. Payments toward principal-only should always be made to loans with the highest interest rate.

If you don't have an auto loan or credit card balances, consider paying the Unpaid Interest plus whatever extra principal you can afford on your student loan. But if you have more than one federal student loan and receive multiple corresponding quarterly interest statements, don't pay extra principal on a loan until you have paid the unpaid interest on all of your student loans, regardless of their interest rates. Any payment amounts that exceed the Total Unpaid Interest will go toward the principal balance, which is not considered tax deductible. If you can afford to pay more than the Total Unpaid Interest on all of your loans, first, write a separate check for each account's Total Unpaid Interest, and then write an additional check for the account with the highest interest rate (probably a PLUS loan) in the amount of your extra principal payment.

If you're a student and you don't have any credit card debt or a high-interest auto loan, pat yourself on the back!

Guidelines for accelerated loan payoffs

If you've been frustrated with the faltering markets lately, as have most Americans, you've probably been discouraged from investing your disposable income into the stock market. That could very well be the correct choice for you and your family, depending on your financial plans and tolerance for risk. But if you're not investing in the stock market, what are you doing with all that money? Are you putting it in a savings account? Or a CD? Or are you paying down debt?

My personal financial plan calls on paying down my debt during the economic downturn. The markets have been unpredictable (and by unpredictable, I mean they're going straight down) and the amount of debt that my wife and I have will take a relatively short amount of time to pay off. We're hoping that when we're out of debt in a couple of years (excepting our mortgage), the market will be trending upward and we'll have a larger portion of our income to regularly invest, given the fact that we'll have no regular payments for our auto or student loans.

If you're going to start paying down debt in lieu of investing, consider the following three guidelines to help you prioritize where your money is being sent:

1. Pay off the loans with the highest interest rate first (as long as they're not tax advantaged)
Dave Ramsey will tell you to pay off your loan with the smallest amount first instead of the one with the highest interest rate. This adds a layer of subjectivity to your personal finance that, while making you "feel good" about paying down your debt, will cost you money. In a recent post, I discuss the financial disadvantages his plan.

Non-tax-advantaged loans that fall into this category include credit card debt, personal loans, and auto loans. Look for your highest interest rate, and start sending whatever extra money that you can to pay it off.

2. Pay off loans incrementally -- don't save your money and pay it off in one fell swoop
I'll give a personal example here. Though I still have a couple of years' worth of payments remaining on my auto loan, I'm hoping to have it paid off by January. While maintaining my "emergency fund" in my checking account, and have been placing my monthly disposable income into an "auto loan payoff fund" that lives in a savings account. Last I checked, I had a few thousand dollars in there.

I had originally planned to keep making my regular monthly payments and continue saving money in the payoff account until I had enough money to pay off the car. But then I crunched a few numbers and found the flaw in my plan. Here's how it goes:

Whenever you make a regular monthly payment on a loan, a portion of that payment goes toward the principal balance and another portion goes toward interest. Those percentages are determined by a couple of different factors:
1) the time left on the loan (the less time left, the higher the percent that goes toward principal) and
2) the amount of remaining principal balance (the lower the balance, the higher the percent that goes toward principal).

So if my monthly payment is $500, maybe $400 of that goes toward principal and the other $100 goes toward interest. Next month, after the principal balance has been slightly reduced, the payment distribution may be $405/95, and so on. But if I have a few thousand dollars in a savings account that's just waiting to be used to pay off the loan, I am better off sending that money as a principal-only payment immediately. If I reduce my principal by, let's say, $5,000, a much higher percentage of my regular monthly payment will go toward principal. If you're paying off a loan on an accelerated schedule, sending the extra money as soon as you have it instead of saving it and sending one big fat check at the end may save you several hundred dollars over the life of the loan.

3) After non-tax-advantaged loans are repaid, evaluate the tax benefits of other loans before repaying them.
Once your credit cards, personal loans, and auto loans are paid off, hopefully all you'll have left is a mortgage and maybe a student loan. At this time, before deciding to accelerate the payoff on these loans, you should reevaluate the stock market. Has it picked up yet? If you're still not feeling warm and fuzzy, do some math and figure out how much your tax-advantaged debt is really costing you.

If your mortgage has a 5% interest rate, remember that depending on your tax bracket, you'll get maybe 25 or 28 percent of that interest back in your tax refund. So think of the effective cost of the debt to be 3.75% (5%, minus 25% of the 5). Your mortgage is a very long-term loan, and you won't see the benefits of paying it down early for a very long time. Paying it off early won't reduce your monthly payments. Sure, it will be paid off sooner, but even if you double your monthly mortgage payment every month until it is paid off, it will take almost 10 years to pay off a 30-year mortgage. If the effective interest rate on your mortgage (the interest rate less the tax benefit) is only slightly higher than the amount you could earn in a CD or a savings account, I would rather see you hold onto that money just in case you need it.

With all loans, especially those that are tax-advantaged, the lower the interest rate, the less sense it makes to accelerate your payoff. My friend Quang's student loan has a 3% interest rate. I wouldn't pay that off early for the world. But the rate on one of my wife's student loans is 7.9%. I can promise you that as soon as my car is paid off, the next thing to go will be that sucker.

Non-tax advantaged debt is nobody's friend. If you're not satisfied with the performance of your investment portfolio, it could be a wise decision to pay it off early in lieu of investing. But if your only debts are mortgages or student loans, think twice before you start sending extra cash toward the principal. True, you're saving yourself money in the long run, but remember that you're also reducing your tax writeoff and parting with that money for a long, long time. And keep in mind: even if you're using the standard deduction (not itemizing), your student loan interest is still tax deductible!

Paying down that mound of student loans

A reader of my site sent me a private message describing an intimidating financial situation that she found herself in. After attending an expensive out-of-state college and starting grad school, she has found herself with $140,000 in student loans. Let me just say this: if your parents paid for your education, call them today and thank them.

I called her while driving back home from a business trip to talk it over. In this post I'll describe to you some of the specifics of her situation, some options that she was considering, the advice that I gave her, and the numbers that I crunched when I got back home, and my final conclusion.

Specifics:
Current sum of balances: $140,000
Current interest rate: varies; different loans have different rates ranging from 4.5% to 7.5%
Current salary: $60,000
Current credit: So-so, but her father has good credit and is willing to co-sign
Current living expenses: limited, as she is living with her grandmother

Options she was considering:
#1 - Buying a house and consolidating the student loan debt into the mortgage:
Her father suggested doing this, but she wasn't sure about her options. I can't say that this is not necessarily bad advice, but it really isn't an option. Here's why:

Depending on your situation, down payment, and credit score, mortgage lenders may be willing to give you some extra cash to help with certain expenses, like necessary repairs or closing costs. However, they're very careful about not giving you too much money, as they don't want the balance of the mortgage to exceed the value of the home because the home is used as collateral.

Mortgages tend to have lower interest rates than personal loans, credit cards, and student loan consolidations. That's because they present less risk to the lender because the loan is secured with an actual house. If you don't pay your loan back, the bank can seize and sell your home. The same goes for car loans. On the other hand, if you fail to repay your student loan or a personal loan, sure, the bank can destroy your credit, but they're S-O-L when it comes to getting their money back.

If my reader were to roll her student loans in with her mortgage, the balance on the mortgage would be $140,000 more than the cost of the home, less the down payment. So unless she was putting at least $140,000 down on the house, the bank would be "upside down" on her loan -- meaning they were owed a lot more than the collateral was worth. Banks don't like to be upside down, so her request would likely be denied.

On a side note, this type of lending and borrowing was a root cause of the recent economic downturn. People bought homes and assumed that, because of the housing bubble, the value of their homes would skyrocket and they would have incredible amounts of equity. Let's say I bought a house for $200,000 with no down payment. At first glance, I would have zero equity. But if after a couple of months the house was assessed at $300,000, my equity would be $100,000 and my bank would potentially loan me up to that amount in a home equity loan. This happened often and sounded great to everybody. But as home values eventually declined, all of that false equity diminished. All of the sudden, people that exercised these types of loans owed $300,000 on a home that was now only worth $175,000...but I digress.

#2 - Consolidating her private loans
My friend has a combination of federal and private student loans. Her federal loans are already consolidated at 4.5% -- a rate I wouldn't part with for the world. Her private loans (which I assume are the majority, given the high sum of her balances) have interest rates which vary from 6.5 to 7.5 percent.

This morning I looked into the cost of consolidating private loans. Turns out, it's more expensive than I had imagined. According to studentloanconsolidator.com, consolidating your private student loans will give you a variable interest rate from 7.9 to 11.93 percent and smack you with a one-time consolidation fee of 1-5%. I've got to say, that's pretty expensive! Of course, there are other options out there, but the consolidation of private student loans are very very expensive, especially considering my reader's current 6.5 to 7.5 percent interest rate.

The advice that I gave her on the phone:
When we spoke, I was in the car and didn't have time to research the total cost of paying back her loans or her consolidation options. I told her that consolidating her loans with a mortgage were simply not an option because she wouldn't have enough equity in the home. I told her to continue living with her grandmother as long as she could stand it and keep sending extra money to her lenders. I told her to start keeping track of her money -- how much she has, where it goes, etc, by using my favorite site on earth, mint.com. Finally, I told her to save a couple of months' pay in an emergency fund.

The numbers I crunched this morning:
Assuming a $140,000 principal balance, a 20-year payback period (common when it comes to loans), and an average rate of 7%, her regular monthly payments are probably somewhere around $1,085 per month. If I knew what her actual monthly payments were, I could be more certain about her average interest rate.

By paying that minimum payment each month, her student loans will be paid off in 20 years. However, if she sends and extra $500 per month toward the principal, her loans will be paid off in just over 10 years. If she can scrape together an extra $700 per month, the loan will be paid off in less than 9 years.

If some of her loans carried a higher interest rate, she could consider asking her father to take out a home equity loan for her. Because he's willing to co-sign on a loan, he's already shown that he's willing to put his credit and cash on the line to help out his daughter. Assuming that he owns his home and has considerable home equity, he could take out a home equity loan with a potentially low interest rate and pay off her student loans. The thing to consider is that home equity loans typically last for 30 years, so this would only be a valuable option for her if she were to 1) pay off the loan early and 2) obtain a lower interest rate than the highest of her student loan rates.

Final conclusion:
My friend is really in no position to purchase a home at this point. Her current student loans really resemble a mortgage. At her current income level, I would expect that she could afford a home worth approximately $140,000 to $180,000 dollars. But because her $140,000 in debt doesn't come with a house, she doesn't have the option to "live in her investment" or rent out a room. I would recommend that she refrain from buying a home until the balances on her student loans are cut down to at least $50,000.

If her student loans each carry different interest rates, she should start by paying down the one with the highest interest rate. Once that's paid off, she should start paying off the next one and the next one and so on. I recommend that she do this methodically and automatically by setting up regular payments with her bank. But she should make sure that the extra payments are going toward principal and not toward next month's payment.

An education is a valuable thing -- and an expensive one, too. Student loans are a part of life for many people, including myself, my wife, and many of our friends. By being smart about paying them down and using all of the resources available to you, you can bring your balance to a big fat zero in no time. Then, you'll be able to start saving that money for your own child's education!

To my reader that called asking for help: feel free to send me an email with the specifics of your loans. I've built some calculators that will help optimize their payoff, ensuring that in the end you're paying as little as possible.

Debunking Dave Ramsey's Snowball Plan for Debt Reduction

A reader recently commented on my site,  suggesting that I check out Dave Ramsey's website and learn about some of his suggestions for getting out of debt.  This morning, I performed a detailed analysis of his debt reduction plan which he calls the "Snowball Plan."

First accumulate $1,000 cash as an emergency fund. Then begin intensely getting rid of all debt (except the house) using my debt snowball plan. List your debts in order with the smallest payoff or balance first. Do not be concerned with interest rates or terms unless two debts have similar payoffs, then list the higher interest rate debt first. Paying the little debts off first gives you quick feedback, and you are more likely to stay with the plan.

I should mention that Mr. Ramsey is a faith-based financial advisor and regularly takes into account more than just the numbers.  When speaking on personal finace, he focuses on the "personal" just as much as the "finance."  Though his system has proven to be effective for some, it is not my style.

He urges his readers and listeners to build momentum when reducing their debt and try to feel a sense of accomplishment.  But let me warn you: those senses of momentum and accomplishment may not come cheaply.  Essentially, by "feeling good" about paying down debt, you risk taking more time to do it and thus wasting more of your money on interest payments.

Consider this analysis:

Let's say you have two loans: A student loan for $25,000 and an auto loan for $10,000.  The student loan has an interest rate of 8% and regular payments of $227 for 200 months.  The auto loan has an interest rate of 6% and regular monthly payments of $304 for 36 months.  In addition to your regular payments, let's say you have $100/month extra that you can apply to whichever loan you're currently paying and that once it is paid off, you will take the normal payments of it and apply them toward the other loan until it is paid off.  In this scenario, with minimum payments of $227 and $304 and extra cash of $100, you will be paying $631 per month until both loans are paid off.

Because the length of the student loan is much longer than the auto loan, even if you decide to apply the extra money to the student loan first, by the time it's paid off the auto loan will have been long-since paid off.  The total you will have spent on interest over the life of the two loans will be $10,603.  If you had decided to pay off the smaller auto loan first and then send all of your debt-reducing cash to the student loan, you would have saved $2,262 in interest.  In this case, Dave Ramsey's strategy works.

But let's look at another scenario.

Let's say you marry your college sweetheart.  After the wedding, you decide to merge your individual finances and adapt a joint financial strategy that works for both of you.  Let's say that you have a student loan of $30,000 at 9% for ten years.  Your spouse has less: only $15,000 at 6% for the same 10 years.  Like the previous example, you can pay an extra $100 each month toward the principal on whichever loan you're paying down first.

The terms (length) of the two loans are the same, one is twice the size of the other, and the smaller loan carries a smaller interest rate.  Dave Ramsey would tell you to pay off the smaller $15,000 loan first.  By doing that, you're costing yourself $1,534 in unnecessary interest.  If the difference in the interest rates was greater, this wasted amount would be even larger.  Let's say your loan carried 10% interest and your spouse's carried 5%.  You would then waste $2,058 in additional interest by paying the smaller loan first.

Let's tweak the numbers one more time: Assuming the same rates and balances,  a change in terms so that the smaller loan lasted for 15 years instead of ten would result in a waste of $2,656 in unnecessary interest payments; just because you listened to Mr. Ramsey.

As you can see, there is not a definitive high-level strategy that can accurately determine the order in which you should pay off your loans.  Mr. Ramsey tries to justify his financially flawed plan by adding emotion and human perception to the equation.  Here is my solution:  When considering the order in which you pay off your loans, crunch the numbers.  Once you prove which will save you the most money, set up a regular payment with your bank and forget about it.  You should find satisfaction in the fact that you're paying off your loans in the smartest, cheapest way possible.  Maybe it means paying off the smaller loan and maybe it doesn't. 

Healthy spending series: Part 1 - Replace costly activities with free ones

Everyone has their ups and downs when it comes to spending money. Hell, I sure had mine! When I graduated from college in 2006, I had about $9,000 in credit card debt that had been a parasite on my bank account for years. On a card with a $5,000 balance, I remember making the $175 minimum payment each month, of which only $25 or so went toward the principal. I had a spending hangover that I'll never forget; one that I hope I never have to experience again.

Like an oversized person commits to lose weight, I committed to drop my debt once I got my first 'real' job. It took a few months of monitoring my finances, but in the end it was less painful than I imaged it would be-- and what a weight it was off my shoulders! Since dropping the debt, I've watched my net worth start to climb, bit by bit, as I gladly pay myself each month rather than Chase. Now that I'm a better place financially, I follow these guidelines as best as I can to make sure that the parasite of debt doesn't return.

1. Replace costly activities with some that are free
Let me first say that it's OK to go out and spend a little money; just like it's OK to eat a cheeseburger for dinner every once in a while -- I mean, we need to eat! But too much of a 'good thing' isn't a good thing for anyone. And overeating is just like overspending. Regardless of your financial situation, it's OK to overindulge now and then. But day-to-day, you should fill your life with healthy spending.

Consider why you shop. Do you do it because you're bored? I know I used to. Going to the mall or to a movie or to a coffee shop are all fine things to spend your time doing, but they could easily be replaced by things that are less expensive or even free. Set a goal for yourself to replace one of your regular costly activities with something that doesn't cost anything. The next time you're considering going to the movies, stay in and watch one you already own (I bet you own quite a few). The next time you're thinking of going shopping for a new cell phone, stay in and call your mother.

The big difference between overeating and overspending is that it's much easier to spot when you've been overeating...Imagine a planet where the more money you wasted, the fatter you'd get. I bet that with such obvious, negative symptoms, the citizens of that place would be much more financially responsible.

[ to be continued tomorrow..."2. Make a shopping list and stick to it ]