Interest rates, monthly bills, and loan balances are all valid considerations when deciding which student loan to pay off first. However, the simplest and most logical strategy is usually to focus on private loans before trying to eliminate federal loans.
The reasoning here is quite simple: private student loans are less flexible and therefore more dangerous for the average borrower.
Federal loans offer forgiveness opportunities, income-oriented repayment options, and interest freezes in times of crisis. Private loans cannot match these borrower protections.
We see exceptions to this basic rule in limited circumstances. Borrowers looking to buy a home might be better off focusing on federal loans. Likewise, financially secure borrowers who are entirely focused on eliminating debt may determine that eliminating their government loans first is the optimal choice.
Debt Elimination and Loan Repayment Order Basics
Before moving on to specific situations and examples, it is essential to clarify one point.
When we talk about eliminating one loan before others, it does not mean completely ignoring certain loans. Missing a monthly bill can mean late fees, adverse credit reports, and worse. Jumping on any student loan bill should be reserved for desperate situations.
The discussion of loan prioritization involves determining where additional payments are best allocated. If your student loan bills total $400 a month and you can afford to pay $500 a month for your debt, which loan should get the extra $100?
Our goal today is to make that extra $100 go as far as possible.
The classic strategy: focus on the loan with the highest interest rate
If you do the math, eliminating the highest interest rate loan will always save the most money in the long run – assuming forgiveness and outside help aren’t available.
When you pay off high interest loans first, as the debt is eliminated, your average interest rate gets lower and lower. The more money applied to the principal, the better off you are.
I generally don’t recommend this classic strategy because it misses the big picture. If all of your loans had the same terms and conditions but different interest rates, eliminating high interest loans first would save the most money. The problem is that not all loans have the same terms and conditions. Since federal loans have better terms and conditions, it is often advisable to leave that for the end.
However, there are times when it is best to cancel the loans with the highest interest rate first.
The classic example is someone who has a good job and job security. Earning a good income alone isn’t enough – while your solid income can quickly disappear, you don’t want private loans hanging over your head. However, if your long-term financial prospects are strong, it might be a case of eliminating debt as quickly as possible. You may not care about loan forgiveness or repayment based on income.
In this limited circumstance, approach the loans with the highest interest rate, as this will likely save you the most money in the long run. Borrowers in this situation can also leverage their earning power to reduce interest rates using a student loan refinance.
Applying New School Psychology to Debt Elimination
Not all borrowers choose to pay off their loan at the highest interest rate first. Some choose to repay the loan with the lower balance.
The idea behind this strategy is that getting a small loan makes it easy for the borrower to earn. Fresh off of success, the borrower is more likely to stick to their aggressive loan repayment plan.
This strategy is not the most effective from an accounting point of view, but given the psychological benefits, at least one study has found it works better.
The problem with this approach is the same as the problem with paying off the loan at the highest interest rate first: no strategy addresses what happens if you lose your job or take a pay cut.
Why eliminating private loans first is best
Under ideal circumstances, whether your loans are federal or private doesn’t matter. Unfortunately, most of us will face a less than ideal financial situation at one time or another.
If you are unemployed, the treatment of federal student loans is radically different from private loans. In the event of a financial crisis, federal borrowers can reduce their monthly federal loan payment to $0. In addition, they can benefit from a substantial interest subsidy. Finally, all that time still counts for the various student loan forgiveness programs.
Extensive federal protections are the reason I advise most borrowers to first eliminate their private loans. It may not be the best strategy from an accounting or psychological perspective, but it is the one that will help borrowers sleep better at night.
Sherpa tip: Another benefit of saving federal loans for last is that it allows borrowers to maximize any new federal programs that may be created in the future.
For example, the recently announced $10,000 rebate program seemed highly unlikely just a year ago. Borrowers who focused on private lending first may not receive up to $20,000 in federal loan forgiveness.
Similarly, during the Covid-19 pandemic, federal borrowers saw their interest rate lowered to 0%. Covid-19 relief is something private lenders cannot offer.
Buying a home can change the repayment strategy
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 ratio (DTI). Mortgage companies look at your monthly DTI to determine how much mortgage payment you can afford.
So, if you’re trying to buy a house, sometimes it makes sense to pay off any loan completely. Other times, the best approach is to eliminate the loan with the highest monthly payment.
Another strategy for those trying to qualify for a mortgage is to ask for lower monthly payments on their loans.
The repayment strategy for borrowers seeking a mortgage gets complicated quickly. There is no simple answer in this situation.
Advanced tips for homebuyers: The ideal approach will depend on several factors specific to each borrower. The Complete Guide to Student Loans and Mortgages should help you identify the repayment strategy that maximizes your chances of getting approved for a mortgage.
Classic Debt Elimination Strategies Don’t Work for Student Loans
Many financial gurus like to urge people to adopt easy-to-understand debt elimination strategies.
The problem with one-size-fits-all approaches is that student loans are much more complicated than most other debt.
The terms of student loans are sometimes extremely harsh. In other situations, they can seem quite generous.
Don’t be afraid to choose the repayment strategy that best suits your student loans. The first loan you pay off should be the one that poses either the biggest obstacle or the biggest threat to achieving your financial goals. For most borrowers, this will be the private loan with the highest interest rate.
Advice for borrowers who don’t know which loan to attack first
If you’re still unsure which loan to pay off first, there are a few other factors that could affect your decision:
- Co-signers – Your co-signer may appreciate you removing the debt they are attached to. Even if you make all your payments on time, the student loan will still appear on your co-signer’s credit report until it’s fully paid off. Plus, if you run into any problems down the road, you don’t want those problems hurting your co-signer as well.
- Get rid of a specific lender – If you have a lender who is a thorn in your side, it is worth considering paying off their loan first. Eliminating their loan means you no longer have to deal with that lender, and that means they stop profiting from your debt. It can be very satisfying.
- Refinance – The refinance option is a wild card. People who desperately need help usually can’t get it, but the stronger your finances are, the more a refinance can help. Some borrowers even choose to use a refinance to lower their interest rates so they can focus on other financial goals like saving for retirement.
As of December 2022, the following lenders offered the lowest refinance rates: