Most personal finance experts say that starting with the highest interest rate loan is the best way to pay off student loans. A few, like Dave Ramsey, say you should start with the smallest balance loan.
Neither approach is the best.
If we were debating which credit card to pay off first, these two blanket strategies are the best options. However, student loans are different.
Federal and private student loans have very different rules. As a result, some borrowers might prioritize paying off one loan before the other. Likewise, student loans behave differently than other debts on your credit report. Your financial goals might dictate paying a specific loan off before others.
Even though it’s impossible to condense student loan strategy into a simple single rule, it isn’t complicated either.
High-Interest Private Loans are Usually the Best Loan to Pay Off First
If you have private student loans at a high interest rate, the analysis for the best order to pay off your student loans is pretty simple.
Private student loans offer the least flexibility in repayment, making them a bigger threat if you run into financial struggles in the future. High-interest debt is also the most expensive.
There are two basic strategies to knock out high-interest private loans:
- Option #1: Aggressive repayment – If you pay the minimum on all of your other loans, it maximizes the cash available each month to pay down your highest interest private loan.
- Option #2: Refinance – Think of refinancing as a shortcut. If you refinance your high-interest private loan, you eliminate the debt and replace it with a low-interest private loan. Refinance lenders fiercely compete on interest rates, and the lenders offering the lowest interest rates are constantly changing.
For many borrowers, eliminating high-interest private loans is the biggest priority. However, there are times when another strategy might be more critical.
Special Rules for Borrowers Trying to Buy a House
Student loans can wreak havoc on a mortgage application.
Student debt can impact your credit score. However, the big consideration for homebuyers with student loans is usually the debt-to-income (DTI) ratio. Mortgage companies look at your monthly DTI to determine how big of a mortgage payment you can afford.
Thus, if you are trying to buy a house, sometimes it makes sense to pay off the smallest loan completely. Other times the best approach is to knock out the loan with the highest monthly payment.
Another strategy for those trying to qualify for a mortgage is to request lower monthly payments on their loans.
Advanced Guidance for Homebuyers: The ideal approach will depend upon several factors unique to each borrower. The comprehensive guide for student loans and mortgages should help you identify the repayment strategy that maximizes your chances of mortgage approval.
Low-Interest Private Loans vs. Federal Student Loans
The tricky decision faced by many student loan borrowers is whether to attack a federal loan or a private loan first.
Suppose you have two $5,000 loans. One is a private loan at 3% interest, and the other is a federal loan at 4.5% interest. From a pure accounting point of view, knocking out the 4.5% interest loan first is the obvious strategy.
However, there are several reasons why you may elect to pay down the private loan first:
When making this decision, I like to look at the higher interest rate on the federal loans as an insurance policy. The federal perks and protections are an excellent resource if things get rough. The extra money you spend each month is the cost of that protection.
If the numbers are close, attacking the private loans first usually makes sense. If the federal interest rates are significantly higher and you are financially secure, paying off the federal loans first might be the best option.
Other Financial Goals
Some borrowers obsess about the best order to pay off their student loans, and they miss the big picture. In many cases, the best strategy might be paying the minimum on all your student loans.
For example, if you have extremely high-interest credit card debt, you probably want to pay that off first.
Finally, some borrowers elect to focus on building their retirement rather than eliminating low-interest student loans.