Taking control of your debt
Having debt can not only feel uncomfortable, it can also hold you back from reaching other financial goals. We recommend the following steps to get a better handle on your loans:
- Know your interest rates
- Evaluate the trade-off between paying down and saving more
- Refinance your outstanding loans
Know your interest rates
The first step in tackling your debt is to know the interest rates on every loan you hold. The interest is what you pay on top of your principal, or the cost of borrowing money from your lender. Here are the average interest rates for the most common types of debt and investments:
Source: Bankrate and Nerdwallet
To be clear, all credit card debt should be paid off every month. Given the high interest associated with it, you'll always be losing out by holding on to that debt. After you have your credit cards in order, prioritize paying down other high interest rate loans first.
For student loans: the interest rate could vary from 2% to more than 10% depending on the type of loan (federal or private), whether they're from undergrad or grad school, and what year you took them out. If you're holding loans with a fixed rate of less than 5%, that may be favorable given the current student loan interest rates. But if you have a fixed rate that's greater than 5%, you may want to consider refinancing your student loans. We address the key considerations of refinancing student loans in a later section. Read more →
Evaluate the trade-off between paying down debt and saving more
If you have extra savings available, you can evaluate the trade-off between paying down the principal balance of your loan faster or increasing your cash savings or investments. The key is to compare the interest rate of your debt with the expected rates of return of your investments. We'll walk you through a few scenarios to illustrate this concept. In the examples below, we assume a reasonable assumption for investment returns is 5% per year.
The interest rate on your loan is higher than the expected return on your investment. What should you do?
Pay off your debt! Your interest rate in this case is guaranteed to cost you more than any potential return could make from investing.
The interest rate on your loan is less than 5%. What should you do?
In this case, investing your extra savings may pay off more in the long run — but this decision has risk. Even if your expected return is much higher than your loan's interest rate, this return on your investment is not guaranteed and subject to market risks in the near-term. But the money you'll save by avoiding extra loan interest is guaranteed. So the conservative option is to start investing once you're free and clear of obligations like student debt — and we think that's the smart thing to do.
Saving in high-yield accounts
While investing does come with short-term risk, it's not your only option for earning a return on savings. These days interest rates on high-yield savings accounts can reach close to 2% — sometimes more! In some cases, this might mean your returns from a savings account could be equal to the interest rate on your loan. If you have yet to build up an emergency fund, you might consider diverting extra cash into a high-yield savings account over paying more (above the monthly principal and interest owed) towards your loan payment. Learn more here →
Paying down student debt faster
If you've decided to aggressively pay down your student debt, understand that these loans are amortized. This means that in the early stages of repayment, your monthly payment is more heavily weighted towards paying the interest owed rather than repaying the principal balance.
To accelerate your student loan pay-off, you'll need to make make extra monthly payments to reduce your principal balance. However, lenders are required to apply extra payments first to the interest that is owed rather than the principal balance. So be sure to research your specific loan to make sure that any extra payments you make will be applied to the principal. If you can't make that change easily on your lender's website, you can contact them with instructions about how to apply your extra payments (the Consumer Financial Protection Bureau has created this template letter to use).
Consider refinancing your loans
Refinancing your loans can reduce your interest rate and shorten the time it takes to pay off the debt, which can translate to significant savings for you. Many people are familiar with refinancing in the context of mortgages, but it has become a more common practice for those with high-interest student loans as well.
If you're evaluating refinancing student loans
Consider more than just the interest rate. If you want to refinance Federal student loans, you may be sacrificing some important benefits, like income-based repayment or the Public Service Loan Forgiveness program.
The financial impact of refinancing will depend on your interest rate, total principal balance and loan term. The example below shows how someone can save $1,471 by reducing their interest rate by just 0.71%.
Source: Student Loan Hero.
TO SUM IT UP
Tackling your debt starts with knowing your interest rates and prioritizing which loans to pay down first. While you may want to begin investing extra savings instead of paying off debt, understand the risks that comes with this choice. And if you think you can get a better interest rate, look into refinancing your loans.Dive into another question →