When I graduated with over $20,000 in student loan debt several years ago, I began to search for tips and tricks on how to pay off student loans more quickly. I knew that there was a hidden secret, an advanced mathematical method that would allow me to cut my payoff time in half. Of course, I expected this would be a complicated solution, one I would have to study carefully and use with extreme precision. But after all of this searching, I was amazed to discover that the best way to pay off student loans actually involves one very simple rule, and I’d like to share it with you.
Before we go any further, please understand that this method isn’t for everyone. If your loans take up a large portion of your monthly income and/or you have other significant debt, you may be better off saving more now and using a program like Income-based repayment with your loans. If your loans are manageable, you have significant extra income and you are aiming for the stability and peace of mind that accompany freedom from debt, then this is the best way to handle your loans.
Pay More than the Minimum Monthly Payment
First off, know that you will be doing yourself a huge favor if you can pay more than the minimum monthly payment on your student loans. I don’t know about you but a standard 10-year payoff sounds like a long time, and I know that time can be cut in half (or more) if you manage your money wisely and put extra income toward your loans. Of course, this isn’t a realistic option for everyone (especially not for those who are unemployed, under-employed, or have lots of other debt).
If you fall into one of these categories, try to make the minimum payments until you get back on your feet. You might also consider deferment or another repayment plan. A student loan counseling session might be able to help you sort it all out.
The (Not So Complicated) Formula
If it is feasible for you to pay more than the minimum monthly payment, you will need to follow one basic rule. This is the simple rule I learned after searching high and low for complicated formulas. It goes something like this:
Put your money toward the account with the highest interest rate.
Yes, it’s really that simple. Following this principle is the best way to pay off student loans and will save you money in the long-run.
Why does it work? Because the accounts with the highest interest rates will grow the fastest, increasing your total payment and extending the length of your payment. By getting rid of these first, you take away your debt’s ability to grow.
Proof that this is the Most Efficient
This is a new section we’ve added to the post on April 10, 2014 in response to numerous questions in the comments. We hope that this answers, for once and for all, any doubts about this method. I struggle at times with wrapping my head around the math involved too, but this should demonstrate that the interest rate is really what matters.
Here’s the hypothetical situation we created. Let’s assume you have two loans with the following characteristics:
Loan A: Principal – $18,000; Interest Rate – 5%; Minimum Monthly Payment – $190.92
Loan B: Principal – $10,000; Interest Rate – 6.5%; Minimum Monthly Payment – $113.55
We’re going to assume that you can make the minimum monthly payments without any problem and that you also have an extra $300 to put toward your loans. Now, there’s two ways you can use your extra money. You can pay off Loan A in full and then pay Loan B. Or, you can pay off Loan B and then pay off Loan A.
If you pay off Loan A first and then put all your extra to Loan B after that, these will be your results:
|Paying off Loan A First|
|Loan||Balance after Second Month||Months of Repayment||Total Paid|
On the other hand, if you pay off Loan B first and then put all your extra to Loan A, these will be your results:
|Paying off Loan B First|
|Loan||Balance after Second Month||Months of Repayment||Total Paid|
|Savings with this method: $361.41|
So the first question you might ask is why the table includes a column for “Balance after Second Month.” While that may not seem important, it really is. Note how the total balance after the second month is lower in the method where we pay Loan B first. This is the sign of efficiency. This is our initial proof that the method works and that by minimizing interest we are taking down the balance as quickly as possible.
You’ll also notice the “months of repayment.” Again, our method is superior. By paying Loan B first, you will complete the repayment in 52 months instead of 53. And, of course, you will also save $361.41!
The savings might not seem like much, but it’s actually pretty significant in terms of overall percentages. And, keep in mind that this is just a hypothetical. If you have a higher student loan total and interest rates with a greater range (say one at 3% and one at 10%), then this method could mean even bigger savings for you.
*We also want to address one other point, which has come up in the comments and in the original post. What happens if you have two loans with the same interest rate but different totals? So for instance, maybe you have a $5,000 loan at 6.5% and a $10,000 loan at 6.5%.
Well, from a mathematical standpoint, there is no difference in the outcome. No matter which one you pay first, you will end up paying the same total amount, and it will take you the same amount of time.
But from a perspective of financial stability, it could be good to close one account, and you will achieve this by paying the smaller loan first. This is what the CFPB advises, as you will see in their letter, mentioned later in the article.
One Obstacle: Finding the Right Information with Your Loan Servicer
Multiple Student Loan Servicers
We have given you a very simple formula for the best way to pay off student loans, but dealing with student loan servicers can be confusing. When you log into the National Student Loan Data System, you might find that you have a handful of student loan servicers. In fact, Federal Direct and FFEL loans rely on 10 different servicers (this is an improvement from the 17 servicers that were being used when we first wrote the article)! Keep in mind that this doesn’t include Perkins loans or any private loans you may have.
It’s very likely that you will have multiple student loan servicers, which means you will make multiple student loan payments each pay cycle (some may be monthly; others may be quarterly). You will also likely have multiple online accounts and usernames, and the whole process can become very confusing. Keep detailed records about your loan servicer and your account information and know that your loan could move to a new servicer at any time. Write down information for each loan you have and include the principal, the minimum payment, the interest rate, and the servicer who handles the loan.
Finding the Interest Rates and Understanding How Payments Are Applied
You will need to understand the terms of each student loan servicer when you make your student loan payments. This might take some work on your part, because the interest rate for your loan can be difficult to find. Some servicers bury this information deep within their website, so be sure to look carefully, and call customer service for help.
It also might be hard to get an explanation about what happens if you pay more than the minimum payment. What will that extra money go toward?
As you know, we want the extra money to go toward the account with the highest interest rate. But will your servicer know to do this?
Here is the policy that Great Lakes (a leading federal student loan servicer) has for extra payments:
Your additional amount will be applied:
1. First to any accrued interest not covered by your regular monthly payment.
2. Then to the principal balance—the amount of money you originally borrowed—of your loans with the highest interest rate.
Interest Rates vs. Accrued Interest
If you are paying more than the minimum and have not missed any payments, chances are that all your accrued interest will already be covered (so #1 above won’t really apply to you). Even if it does apply to you, keep in mind that it’s still more important to focus on interest rates, not accrued interest.
Let me explain quickly, using this example:
|Loan Type||Balance||Accrued Interest||Interest Rate|
According to the Great Lakes method, an extra payment here would be applied first to the $13.17 of accrued PLUS Loan interest and to the $28.33 in Stafford Loan Interest. But we know better. We know that interest rates are more important than accrued interest. Even though the Stafford Loan has more than double the amount of accrued interest, it should not be your priority. As a percentage, the PLUS Loan is still growing more quickly. If it was up to us, we would put all of our extra payment toward the PLUS Loan.
However, if you let interest accrue on a loan (the Stafford Loan in this example), it’s principal will increase through what is called capitalization. If this happens too much, your minimum monthly payment may increase. Loan servicers often try to prevent this from happening (as with the policy from Great Lakes).
When Student Loan Servicers Bundle Loans into Groups
What can also create confusion is when a student loan servicer bundles multiple loans into a group. For example, let’s say Great Lakes handles four of your student loans, and they label them Loan A, Loan B, Loan C, and Loan D. Then, they break into two groups:
Group 1: Loan A (5%) and Loan B (4.5%)
Group 2: Loan C (3%) and Loan D (6.8%)
In this case, you want to make sure your extra payment goes toward Group 2 and then Loan D. For some servicers, you might be able to select “Group 2.” For others, this may be done automatically.
*The best way to make sure that your student loan payment is put toward the right loan is to call the servicer directly. Write down the name of the representative and make sure that the payment is applied correctly.
*October 2013 Update: the CFPB has released a sample letter to send to each lender, telling them how to apply your payments. Check out the letter template, fill it out for each lender and send it out so your loans are paid in an efficient manner.
Another tip to pay off student loans: Bi-weekly Payments
You might be able to save even more on your student loans if you pay bi-weekly instead of monthly. This way, you get an extra payment in each year (the equivalent of making an extra monthly payment) and you save on interest because you don’t give it as much time to accumulate. This could be a good strategy to incorporate, as long as you remember that interest rates are king when paying off student loans. This method may not work if you’ve enrolled in automatic payments (which usually come with a reduced interest rate).
What about Taxes?
We have received quite a few questions and comments about the tax deduction you get for paid student loan interest. On the surface, it seems like this might create a situation where you should not follow our “efficient” method so that you can get the deduction. But really, that’s not the case. We created another post that goes more in-depth on this and provides an easy to follow math example: Student Loan Tax Deduction and your Repayment Strategy.
Let’s Review the Best Way to Pay off Student Loans
The best way to pay off student loans basically comes down to three strategies:
- Make more than the minimum monthly payment.
- Put extra money toward the account with the highest interest rate.
- Make bi-weekly payments or enroll in automatic payments to reduce interest.
Despite my initial gut feeling that this process would be drawn out, mathematical, and difficult, understanding how to pay off student loans is actually pretty simple. Just remember that the best way to pay off student loans starts with the interest rate. The interest rate determines how quickly your debt will grow. If you can eliminate accounts with high interest, you can keep your debt from growing and will become debt-free in less time. For another example, check out our post on the debt ladder.
If you are struggling to make the minimum monthly payments on your student loans, or if you have any other student loan questions, consider signing up for a student loan counseling session!