You’re finally out of school! I’m sure it’s a relief to no longer need to worry about homework, final exams and eating gross cafeteria food. Unfortunately, being out in the “real world” comes with its own set of worries, such as paying off the debt you’ve collected along the way.
If that first job out of college has given you extra funds, and you want to pay down your debt faster, these are the three factors you should consider.
What Types of Loans Do You Have?
No two people are the same, so no two financial situations are the same. Depending on where you live, where you went to college, what your financial background is and many other factors, you will have a unique set of loans. A few common examples of loans young adults have include student loans, auto loans, credit card debt and potentially even a mortgage. Each of your loans will have different interest rates, lengths and provisions that make some more beneficial to pay down faster than others.
What Interest Rates Are You Paying?
The rate you receive on a loan is influenced by the type of loan, term or length of the loan, your credit score and a variety of other factors.
Depending on the state of the economy when your loan originated, the specified interest rate in your loan contract could be higher or lower than current market rates, which are simply the rates you’d receive if you took out a loan today. If you are paying a fixed interest rate and current market rates are considerably lower, it may be worth your while to refinance your loan in order to lower your interest payments. On the flip side, if your fixed interest rate is lower in comparison, you are lucky because you’re paying less than what a new loan would charge you.
Sometimes a loan will have a variable, or floating, interest rate. Loans with this rate structure may be enticing because they can offer lower rates than what you find in the market, but it won’t last. If current market rates go up, so will your loan’s interest rate. This will result in a higher monthly payment than you previously had.
Interest rates affect not only the amount you pay every month but also the total amount you pay by the time the loan is paid off. If you have a simple interest rate, like on many auto loans, the interest charged is only calculated on the principal remaining, which is the amount you still owe. On the other hand, if you have a compound interest rate, the interest you are charged is based off the principal remaining plus any interest you’ve accumulated. Basically, you’re paying interest on interest. This is the costlier of the two rates, and it’s also the most common. You’ll find it on your student loans and credit cards.
What Are the Lengths of Your Loans?
As mentioned earlier, part of what affects your interest rate is the length of the loan. Typically, long-term loans have higher interest rates than short-term loans. Why is this? The higher interest rate serves as a form of protection for the lender against default risk. In other words, as the length of the loan increases, so does the risk that the borrower won’t be able to pay back the full amount due to unforeseen circumstances. The lender charges a higher rate to make up for potential future losses.
Lower rates can make short-term loans appealing, but when it comes down to it, the monthly payments may be too high for some people to afford. Longer-term loans can be more affordable due to smaller monthly payments, but you’ll end up paying more due to interest.
How to Prioritize
Once you know the types, interest rates and lengths of your loans, you’ll be ready to prioritize which ones would be most beneficial to pay off a little faster.
Typically, credit card debt should be the first loan you put your extra money toward. Credit card interest rates are often considerably higher than other loan rates — usually between 15–20%. Additionally, credit cards have a compounded interest rate and no specified term, providing you make the minimum monthly payment. Without an ultimatum as to when the credit card balance is due, many people tend to only pay a portion of their bill, which allows interest to exponentially accumulate. By paying off your credit card debt, you will save yourself a lot of money in interest payments and can use those saved funds for other things.
Once your credit cards are paid off, or if you don’t have any credit card debt to begin with, you should compare the interest rates, remaining balances and terms of your outstanding loans. Take the highest compounded rate loan and look at the term and the balance remaining. If the loan still has several years before it comes due and a large balance, it would be an ideal one to pay down faster and save yourself from accumulating a large amount of interest. If there isn’t a large balance and only a short term remaining, it usually isn’t as beneficial to pay it off early.
If your highest rate and longest-term loan happens to be either student loans or a mortgage, there is one other matter to consider: tax deductibility. Having either of these loans means you can save money on taxes even if you’re not saving money on interest. Being able to deduct the interest you pay is a perk of holding onto your student loans and/or mortgage, but it is up to you if the tax deduction is enough incentive to keep these loans instead of paying them off sooner.
Food for Thought: Should You Even Be Putting Extra Funds Toward Debts?
Unless you are the type of person who doesn’t like to have debt, paying down debt faster may not be the most beneficial way to spend your extra dollars (except if you are paying off your credit cards). Sure, it may save you money on interest payments, but you could potentially earn more in the long run by investing those excess dollars than you’d pay in interest. You may have just graduated, but it’s never too early to think about your future needs, and even retirement.
At the end of the day, how you spend your excess funds is up to you. If you decide to spend them to pay off loans faster, use the tips above to strategically pay them off. If you want to learn more about investing your money in the market instead, speak to a financial advisor or click here to read one of our blog posts on the topic.