This article could have gone in a million directions and I’m going to choose the easy one. Just presenting a mathematical exercise on how to pay off your student debt faster.
[ Here’s the spreadsheet that I’ll be referencing, just make a copy and you can edit the yellow fields with your own information. ]
From my understanding, there are a few repayment plans, 10 years and 20 years are the most common, so in this exercise, I’m just going to use those two plans and the following assumptions:
Student loan amount: $30,000
Interest rate: 3.75%
10-year plan monthly payment: $300.18
20-year plan monthly payment: $177.87
Initial daily interest rate: $3.08
So if you were to do nothing special and just paid your monthly’s, you would pay your $30k balance off in 10.0 years or 20.0 years depending on the payment plan.
However, if you were to simply change your monthly payments to bi-weekly payments, you could shave off just about 1 year on a 10-year loan and a little over 2 years on a 20-year loan. The reason is that you’re effectively making one additional payment per year since a year has 52-weeks which is 26 payments if you’re paying bi-weekly.
Interestingly, 36.5% of all employees in the United States that work for a private company are paid bi-weekly and 32.4% of employees are paid weekly per the Bureau of Labor Statistics, so effectively 70% of all employees could budget for a bi-weekly student loan payment.
Student Loan Forbearance due to COVID
Right now during COVID, since there is forbearance on student loan repayments and a 0% interest rate until at least January 31, 2022, if someone started paying down their balance in April 2020, this would have shaved off 7 months on a 10-year loan and 1.75 years on a 20-year loan. If bi-weekly payments were made over this same period, this would result in shaving off 1.6 years on a 10-year loan and nearly 4 years on a 20-year loan. This is largely due to the borrower not having to pay about $2,000 in interest over this forbearance period.
Daily Interest & Making Extra Payments
It’s important to know that the interest on your student loans during a non-forbearance period is accrued on a daily basis. So a $30k loan at a 3.75% interest rate means you will accrue $3.08 in interest every day (This is calculated by taking the principal amount and multiplying it by your interest rate and dividing by 365 days, i.e. $30,000 x 3.75% / 365 = $3.08) So if you want to “get ahead” of the interest in order to pay off principal, you will need to keep that in mind that any incremental payments you make will always be offset by the daily accrued interest. So if you make a monthly payment on the 1st of the month and then choose to make an additional payment a week later, you will have to first pay off approximately $21.50 (7 days x $3.08) in interest before any principal begins to be paid down.
With that said, if you were to add $50 to your monthly repayment plan or $25 bi-weekly, you would shave off 1.7 years off your 10-year loan, 2.5 years off your 10-year loan with bi-weekly payments, 5.8 years off your 20-year loan and 7.9 years off your 20-year loan with bi-weekly payments.
So a little does go a long way. You effectively cut your repayment period down by 25% on a 10-year loan with just $25 more every other week or 30% on a 20-year loan with $25 more every other week!
Should You Make Extra Payments or Pay Off Your Loans ASAP?
More often than not, this decision is a personal one. The decision to pay off your student loans faster than planned is comparable to paying off a mortgage early. It really depends on how comfortable you are with having debt and having to make monthly payments.
My personal opinion is that if the interest rate is less than 3%, you should just make the minimums and invest everything else since you can probably get a return greater than 3% investing elsewhere. If the interest rate is 3-5%, I would probably be inclined to throw some additional money at the principal to pay off the loan faster, especially if it’s closer to 5% than 3%. If the interest rate is greater than 5%, I would probably try my best to pay off the loan as soon as possible given how high the interest rate is.
For some context, after I graduated from business school, I had just around $100k in student debt with 70%+ of it at a 7.9% interest rate and I spent the better part of 3+ years using the majority of my paychecks and bonuses to pay down my principal balance. My reasoning was that it’s difficult to achieve a 7.9% after-tax return given that the S&P 500 generally generates 8-10% pre-tax returns annually.
Parting Thoughts & Other Considerations
Student loans suck but you can make them more manageable by simply making small adjustments to your student loan repayments. Remember, even just a small amount can make a big difference in your overall repayment term. Always remember, every payment you make, whether it’s once a month, twice a month, or more than that, will reduce your principal balance as long as the payment offsets the daily accrued interest.
If you are interested in making bi-weekly payments, you should definitely contact your student loan servicer to ensure that this is something that you can do. If they don’t offer that option, you can always make extra payments.