Follow the Allocation Crossing Point & Step-Down Method instead
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I have spent a good amount of time browsing through student loan boards and accounts on Quora, Reddit, Instagram and Twitter, and was surprised by how many people are asking: how do I pay down my loans as fast as possible?
That is the wrong question.
Instead, all borrowers with student debt should ask: “how do I optimally *minimize* my interest payable?”
It doesn’t roll off the tongue as beautifully, I know. But when you will see, for example, that you can pay off your debt just as quickly while saving yourself $10,000 over the next few years, which you can use towards other investments or savings goals, I don’t think you’ll care how the “interest payable” question sounds.
The core issue is that people incorrectly think debt is bad. It’s an outlook that has been passed down over the generations, probably reaching back to the great depression.
I’m here to tell you DEBT IS NOT INHERENTLY BAD. Debt is only as bad as its daily interest is high!
Notice that I did not reference the interest rate, but rather the daily interest. This is because the interest rate is one set number, but the daily interest decreases every month as you pay down your debt.
Therefore, daily interest is a function of your interest rate AND your loan balance, and it represents your key towards getting the most value out of every extra dollar you pay towards your loan.
For this article, I am assuming that you already know that in order to minimize your interest payable, you need to continue making your minimum monthly loan payments plus pay extra whenever possible. Therefore, all references to payments in this article relate to the extra payments.
Realizing you have extra money in your budget that you can allocate towards paying off your debt is very exciting! But then a series of questions arise: which loan should I pay more towards? How much more should I pay (every month)? Should I refinance? Could I get a better interest rate? Is it better to lower my interest rate or, if I have federal loans, hold on to the flexible repayment options in case of hardship?
I will address the refinancing question in a future article.
This article will introduce a new repayment method that is more personalized and will help you get the most value out of every additional dollar that you contribute towards your loans.
Introducing the Allocation Crossing Point and Step-Down Method to Loan Repayment
Earlier this year, I wrote “Should You Pay Off Your Student Loans or Invest?”. I explained that common advice around debt repayment is costing people money because it is too generic and overly simplified. In today’s digital and personalized world, we need financial advice that is easy to follow but also based on our unique situations. That is why I developed the Allocation Crossing Point (ACP) and Step-Down method.
Allocation Crossing Point (ACP) is defined by the month when less than 50% of your minimum monthly payment starts being allocated towards interest, meaning every additional $1 contributed towards your loan will save less than $1 of interest.
Step-Down Method represents the repayment technique that you may seek to employ after the ACP is passed. Since the ROI of every additional $1 drops below 100%, you should start contributing less than your maximum available net cash flow if you want to optimize repayment.
The money that you do not contribute towards your loans can go towards other investments or savings goals so you avoid getting into crippling debt again.
If You Have Multiple Loans
Consolidating or refinancing a loan is not always the right option. In these situations, a borrower is left with multiple loans that have different principle balances, interest rates, loan terms, and monthly minimum payment amounts. How should a borrower determine which loan he should pay more than the minimum towards?
Common techniques include the debt snowball — organize loans by outstanding balance and pay off the smallest one first — or debt avalanche — organize loans by interest rate and pay off the highest rate first. These approaches focus on finishing loans off one at a time but, as I explained earlier, the goal should be interest minimization and not loan elimination. Since these approaches focus on the wrong goal, they could end up being very costly. I recently spoke with borrowers and helped them recognize that, relative to the Allocation Crossing Point method, the debt avalanche method would have them paying around $10,000 more to finish their loan only 4 months earlier and save only around $200 of interest. That represents only a 2% return on investment — $200 of interest saved for $10,000 of extra payments! If the borrower has other investments in mind, or goals they want to save money for, wouldn’t it be better to follow a repayment method that can give the him/her the option to seek a higher return on investment?
Yes, I do believe so.
The way to follow the Allocation Crossing Point method when you have multiple loans is simple:
- Calculate the daily interest that accrues on each loan. Remember, the daily interest is your key to getting the most value out of every extra dollar that you contribute towards paying off your loan.
Daily Interest = (interest rate / 365.25) * current loan balance
- Apply your extra funds to the loans that have the highest daily interest
(Example: if the daily interest on each of your four loans is $7.10, $6.90, $2.50, $2.45, and you have $1,000 of extra money to contribute, then you may want to pay an extra $600 towards the loan that accrues $7.10 and $400 towards the loan that accrues $6.90 of daily interest.)
- Repeat steps 1 and 2 before each payment to determine which loans are accruing the most daily interest. This means you will have to do some simple math every month, but it could save you tens of thousands of dollars.
The Step-Down method should be leveraged after the Allocation Crossing Point is reached. You can identify this point in two ways.
One way is by logging into your online loan account and seeing what percentage of your minimum monthly payment is going towards principal vs interest. If more than 50% of your monthly payment is going towards interest, then continue paying as much as you can towards the loans that have the highest daily interest accrual. If more than 50% of your monthly payment is going towards principal, then the Allocation Crossing Point has been reached.
The second approach is more relevant for people who recognize the goal should be interest minimization, but still want to get rid of their debt quickly. In this case, continue paying as much as you can towards your loans that have the highest daily interest until the daily interest — as calculated in step 1 above — drops below $2.00 or $3.00 per day.
Either of the two approaches will help you identify when you can “step-down” your extra payments. This means that, for example, even if you have $1,000 that you can contribute towards your loan, you may want to contribute only $800 and keep the extra $200 for other savings or investments. You want to do this because the ROI of every additional $1 drops below 100% after the Allocation Crossing Point.
By stepping-down (decreasing) your extra monthly loan payments after the Allocation Crossing Point, you can start to allocate that money towards other savings goals or investments that might be able to offer you a better return on investment.
If you would like free access to a spreadsheet that formats this information for you, please email me: FiscalHappiness@gmail.com
If You Have One Loan
The approach for optimizing repayment of only one loan is very similar to the multi-loan approach. The only difference is that it’s simpler because you do not have to decide which loan to allocate more towards!
Therefore, you can skip over calculating the daily interest accrual and move on to determining if you should either maximize or step-down additional payments.
As mentioned in the last section, this is based on the Allocation Crossing Point which can be determined in two ways.
One option is to log in to your loan account and see what percentage of your minimum monthly payment is going towards interest vs principal. If more than 50% is going towards principal, then the Allocation Crossing Point has passed, and you can start to step-down your payments by a couple hundred dollars. If not, then continue paying as much as you can towards your loan until more than 50% of your minimum monthly payment starts going towards principal.
The second approach is for people who recognize that the goal should be interest minimization, but mentally want the satisfaction of being debt free. In this case, continue making extra payments until your daily interest accrual (=interest rate/365.25 * current loan balance) equals $2.00 or $3.00. At this point, start to step down your payments. You may extend your repayment horizon by a few months and pay a couple hundred dollars more in interest, but you could save yourself many thousands of dollars of extra payments which could be allocated towards other investments for a higher ROI.
If you would like to talk through the step-down method and how to apply it to your unique loan scenario, you can email me at FiscalHappiness@gmail.com
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