How Much Extra Should You Pay On Student Loans?

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As the class of 2010 steps into the real world, another year of students will have to start paying their student loans soon. Most student loans allow anywhere from 3-6 months before interest starts to accrue so students have time to find a job before starting the repayment process.

Once the interest kicks in it can add a lot to your loan. When you break down the numbers and look at the percentage of your payment going to principal and percentage going to interest, it can be quite disturbing.

Here’s the breakdown of how much each payment goes to interest vs. principal in the first 6 months of a $10,000 loan at 7%:

About half of each payment is going straight to the lender in interest payments and barely making a dent on the loan’s balance.

Seeing these numbers may persuade you to increase your loan payments in order to pay less interest over time. But how do you figure out how much extra you should pay towards your loan every month?

Here’s a guide to help you decide how much extra you can afford to pay towards your student loan every month.

First, organize your loans by the size of the interest rates. Open a spreadsheet and list all of your loans, the principal, the minimum payment, and start with the highest interest rate on top. Anything over 5% is a priority for accelerating payments.

Find out how much each loan will cost you in interest. Use this student loan calculator and plug in the specifics of your loans. How much will each loan cost you in interest if you just pay the minimum? Write this number down in your spreadsheet.

The cost of a loan is misleading. A $5,000 loan at 6.8% with $50 monthly payments ends up costing $6,904 – with $1,904 in interest.

Mark your loans as high, medium, or low priority. High priority loans will be anything above 7% because at this point you’re better off throwing extra payments at your loans instead of investing. Paying off a loan gives you a guaranteed return on your money where as short-term investing is dangerous.

Medium loans are anywhere from 3-7%. Investing will trump paying extra on these loans because their rates aren’t devastating. Eventually when your high priority loans are paid off, you’ll start paying extra on your medium loans because you’ll end up paying thousands and thousands in interest if you just pay the minimum for the loan.

The low priority loans are below 3% and you’ll only pay the minimum on these unless you stumble into a large sum of money. These are your favorite loans because they’ll cost you very little in interest and you’ll be able to set up automatic payments and forget about them.

Before you pay extra on any high priority loans (>7%):

1. Have an emergency fund in place. If you live on your own, this should cover 3-6 months of living expenses. You can’t risk losing your job and having no savings so make sure you have a sizable rainy-day fund insuring your job. If you live at home, you can get away with having significantly less in your emergency fund and paying off your loans earlier will be easier.

2. Invest enough in your 401k to get the company match. If your employer offers a 401k with a company match, you need to take advantage of it. This is free money and shouldn’t be avoided, even if you are carrying high interest loans. You’re young so starting your 401k off now is beneficial for compound interest.

3. Look at your income and see how much you can afford to pay every month. Even an extra $50-100 a month will speed up the process and save you tons on interest in the end. If you hate loans, you may want to put as much as $250 extra towards your loan payments. If you’re content with your loans, then $50 extra is sufficient and will allow you to build up your savings else where.

Before you pay extra on your medium priority loans (3-7%):

1. Have an emergency fund

2. Max out matching 401k contributions at work (free money)

3. Max out your Roth IRA. The 2010 tax year allows you to invest up to $5,000 in a Roth IRA. This is money you won’t be taxed on when you withdraw in retirement, so max this out before you start paying off any medium priority loans because the market historically returns 7-8% (although this is never guaranteed). Starting your Roth now will allow it to grow exponentially faster when you’re older and you’ll be glad you started your Roth at 25 instead of paying an extra $75 towards your loans.

You can invest up to $5,000 but you can also invest any amount lower than that. You have until April 15th, 2011 to invest in a Roth for the 2010 tax year.

4. When the above 3 are complete, pay an extra $50-100 on your medium loans (3-7%). Start with the highest interest rate and work your way down.

Before you pay extra on your low priority loans (less than 3%):

1. Have an emergency fund

2. Max out 401k to get the company match

3. Max our your Roth IRA

4. Start building up specific savings goals (car, house, grad school, baby, etc.). The twenties are an expensive time in your life with a lot of huge purchases. Having extra cash around in your savings account will be beneficial. Open up a sub-savings account at your online bank to help save for specific goals.

5. When the above 4 are complete, pay an extra $50 a month for your low priority loans. At this point, you’ll be financially steady and you’ll end up savings yourself some extra cash by paying down these loans as well.

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Although student loans are an annoying burden that we all want to get rid of immediately, it’s important to take care of other areas of your financial life first.

Here’s a student loan calculator that allows you to see how much extra payments will help your debt situation. You can also figure out credit card debt within the same calculator.

Debt affects people differently so your priorities might be different from my suggestions above. But accelerated payments if you have the funds will save you tons on interest in the end. Run the numbers and get a system going for knocking out your student loans earlier so interest doesn’t dominate your life for the next fifteen years.

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