What Would You Do? Pay Off Higher Interest Rate or Variable Rate Loans First?

Pay Off Variable or Fixed Rate Student Loans First Follow Me on Pinterest

Welcome to the fifth edition of “What Would You Do?”! If you have a question and would like to know what others would do please contact me and I’ll keep it in mind for future editions of “What Would You Do?”. Recently I’ve asked Should I Buy a SmartphoneShould I Buy the NeatDesk or NeatReceipts ScannerWhat Would You Do With $1,000,000, and Should I Pay Off My Car Loan! Now on to today’s What Would You Do…

My girlfriend has a few different student loans as I discussed in our debt paydown strategy. They are at different interest rates and to complicate things further some have fixed rates and others have variable rates. There was a clear choice as to which loan she should pay off first. She is currently working on paying off an 8.25% variable interest rate loan that originally had a pretty hefty balance. After she pays that loan off things are going to get tricky.

The Loans and Other Necessary Information

After my girlfriend pays off her 8.25% loan she will still have three fixed rate loans at an interest rate of 6.8%. These loans have a current balance of right around $20,000. She will have a variable rate loan, currently at 5.75% (based on the prime rate), with a current balance of approximately $23,000. Finally she has another variable rate loan, currently at 4.75% (based on the prime rate), with a current balance of approximately $8,000 left on it.

I personally have been saving money to help her pay these loans off. Once we get married one day I’ll take that money and apply it to her loan balances. By that time her 8.25% loan should be paid off but the question remains… which loan should she attack next?

The variable rates will change based on the current interest rate environment. For this exercise let’s assume that the rates are the same as they are today. We hope to have these paid off before the end of 2015 and the Fed (the agency that controls interest rates in the United States) seems to indicate they won’t be raising interest rates before then anyway so hopefully that is a safe assumption.

What Would You Do?

As we see it there are two options for us. We are aware of Dave Ramsey’s debt snowball method (pay the smallest balance off first) and the debt avalanche method (pay off the highest interest rate first). We aren’t a fan of the snowball method because we’d like to pay the least amount of interest possible. This would suggest we use the avalanche method and attack the 6.8% fixed rate loans next, then go on to the 5.75% and 4.75% variable loans.

On the other side, we are aware that the economy might get better faster (we can hope right?) or maybe inflation will start to grow out of control. In that case the Fed might start raising interest rates rather quickly which would lead to an increased interest rate on her variable rate student loans. If we can’t pay the variable rate loans off quickly after rates start going up we could end up paying a lot more in interest. These loans don’t have small balances that can be paid off in a month or two.

The other option (as we see it) is to pay off the variable rate loans (5.75% and 4.75%) before the fixed rates (6.8%) loans. While we might pay a bit more in interest this way there would be less uncertainty in total interest paid. Once the variable rate loans are paid off the most interest we could ever pay is 6.8% regardless of the Fed does to interest rates in the future.

Now that you know the options we have considered what would you do? Is there an option we have missed? Would you pay off the fixed rate loans first or knock out the variable rate loans? Let me know in the comments below and be as specific as possible. We’d love to get as many opinions as we can so we make sure we didn’t miss anything.

photo by: Images_of_Money

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About Lance Cothern

Lance Cothern, a Certified Public Accountant (CPA) licensed in the Commonwealth of Virginia, is the founder of Money Manifesto. You can read more about him here or connect with him on Facebook, Twitter, Google+ or Pinterest.

Comments

  1. Personally, I would do whatever relieves the most stress for you and your girlfriend. If the thought of rising interest rates keeps you up at night, I would definitely pay the variable loans off first. However, if you need those “quick wins” as Dave Ramsey would put it, pay off the lower balances first. As is always said, personal finance is just that, personal. Do what works best for you!

  2. I assume the 6.8% ones are federal loans, so you want to leave them out of the equation for now… but Is it an option to consolidate the variable rate ones into a fixed rate? Preferably a fixed rate that’s locked in low due to the current interest rate environment? That could clear things up a bit.

  3. Even though a few of my loans are variable, we’ve stuck with the Dave Ramsey method as it is nice to be able to knock out the lower ones more quickly. For me it would ultimately depend on how large the gap is between the various loans. For instance, my fixed rate loan is at $4,000 but my larger (variable) loans are at $11,000. That’s a pretty big gap and would take a long time to see and feel progress in terms of eliminating the debt.

    Having been a master of paying off lots of debt, I’ll say there is a huge emotional/momentum attachment to finally eliminating a debt. Even though you’re paying something down (and you know that in the back of your mind), it doesn’t feel as if you’ve gotten anywhere until it’s finally gone.

  4. The snowball method is good, and is one I tend to prefer. That said, you do bring up a great point about paying the lowest amount of interest as possible so you can have more of the payment attack the principal. It sounds like a good plan, as long as you keep an eye on what the rates are doing.

    • I’m not a huge fan of the snowball method, just a personal preference thing. I’m glad it works for others though and do think people need to know about it to make their decisions.

  5. If I were advising you back in “the day,” I’d recommend paying the 5.75% variable rate, if it can’t be consolidated into a lower fixed rate loan. Here’s why:

    - You’ve proven (through previous posts) that you don’t need the “emotional” evidence of the snowball method other commenters have recommended above.
    - If interest rates DO change, which way are they going to go? They can’t go much further down, so your risk is that they rise before you’re done.
    - The interest rate gap is tight enough between the loans that you could potentially end up paying significantly more for the 5.75% loan if interest rates rise.

    It’s a risk/reward thing, right? I’d also ask you this question: Which scenario would make you feel worse? Interest rates rise and you didn’t pay down the variable rate loan OR interest rates didn’t rise and you paid off the variable rate loan first?

    I like assuming I made the wrong choice (taking into account future events we can’t predict) and calculate which has the bigger downside risk.

    • Joe, I like your style. You sounds like you were a financial advisor or something… I like the question about which would make me feel worse… definitely have to consider that when she moves on to the next loan.

  6. I think it depends on what kind of money you have access to and how long your term is. If you can work out a way to pay the higher one off first before your variable term is up, then I would do it that way. If not, than variable makes sense to be the first one.

  7. I would go for the higher interest rate now, pay it off and after that attack the variable, Will be betting on interest rates staying low for some time. However, at the end what matters is to pay these loans systematically till they are gone – the interest rate affect things very little.

    • It is true that we are talking about saving just a few hundred or maybe a thousand or two dollars between the options. I agree that the biggest goal is to get them paid off.

  8. Personally I’d take the risk of focusing on the one with the highest interest rate now. Since you have a side business that will likely grow a lot in the next few years, you will likely be able to knock the entire debt off sooner than you are planning. Also as the debt total shrinks, you may be able to get a line of credit with your bank with a lower interest to transfer the balance to. Or you could apply for a credit card with a long 0% balance transfer option. So as the debt shrinks, you have more options to avoid interest. To me this would mean you should be doing what you can to avoid current interest charges now.

    • Haha I hope my business grows Jeremy! Thanks for the vote of confidence. I think the LoC would be at a higher rate than the student loans though but I haven’t looked into it yet.

  9. Man, this is a tough one. I DO like the snowball method, because I agree with Dave Ramsey that finances are 80% behavioral and 40% math (see what I did there? ;) ).

    I would go snowball because you are already building up a huge avalanche for when you get married, and you can kill the larger loans with that chunk of cash. Knocking out a loan permanently will fell pretty awesome, and help keep you on track.

    • I think we’d both feel a bigger victory getting rid of the highest interest rate loan she is paying off now. It was one of the largest and had the most insane interest rate of them all.

  10. Justin @ The Family Finances says:

    This doesn’t have to be an either/or situation. Another strategy is to hedge both ideas and split your extra loan payments between the fixed and floating rate loans. You know for sure you wouldn’t be paying the least amount of interest, but you’d also know for sure you wouldn’t be paying the most amount of interest.

  11. While I think it’s good to consider these options, you really don’t need an answer now. Your gf has a while yet before even finishing the high interest rate loan, right?

    Like AJ said, interest rates are going nowhere but up – but they probably will stay where they are for a few more years. So I would say just re-evaluate where you think the prime rate is going whenever that first loan is paid off. If think look like they are going to stay low, go for the 6.8% fixed, but switch as soon as you see indications that the rate may go up.

    • Hopefully her current loan is paid off in the next year but it just really depends on how many extra shifts she picks up at work and a couple other variables. We aren’t making a decision yet but I definitely wanted to figure out what others thought. Thanks for the input!

  12. I agree with Modest Money, go after the 6.8% loan for now.

  13. This is more than just a numbers game. But, going with your that interest rates stay low, it makes sense to pay off the loan that is costing you the most first. However, personally, I would get shed of the variable rate loans – you just don’t know what your future liability might be with those.

  14. You mention that there are 3 different loans that make up the 6.8%… I think that puts you in a pretty good spot – you get the mental “wins” as they are paid off, plus you pay off the highest rate loans. Given the recent Fed announcements, I would stick to the highest rate and leave the variable ones for now. Should the winds start to shift a lot, you can always redirect, but my crystal ball guess says interest rates will remain fairly low for awhile. They have to increase an entire percent before they’re the same cost as the fixed rates and that will take awhile.

  15. Jason Clayton | frugal habits says:

    I personally used a variation on the snowball method in the past, Of which I call the snowball + (plus), I’ve written about it before, but essentially it involves debt consolidation with the snowball method. An easy example would be to roll over your credit card debt to 0% interest and than institute the snowball method on it. Works amazingly well.

    • The 0% credit card is definitely an awesome option. You just have to hope that nothing happens to throw you off your game. That or you don’t transfer the max amount you can afford… interesting thought. Thanks for the input.

  16. It’s hard to really tell without see the real numbers and %. I’d also like to see the variable turned into a fixed amount and then use whichever works for you. I’d push for debt snowball, but if you have proven in your past you can handle the avalanche method–set it on auto and worry about making money to throw at the debt.

    • We can handle the avalanche. The problem is we can’t consolidate at all from everything I’ve looked into and NO ONE seems to consolidate student loans at a fixed rate anyway… would be nice if we could though so if you know of something please send it my way! Thanks for the input.

  17. I would pay the highest interest rate first. It is unlikely that the variable rates will increase in the near future.

  18. All other things being equal, I”d prioritize the higher fixed rate loan first… but if the rates on the variable rate loans shoot up, I would take the opportunity to re-prioritize. There’s no reason to consider the variable rate loan more risky. Once and if it becomes more expensive than the fixed rate loan, you can always reassess the plan.

  19. I would recommend paying the highest interest rate. I’m a numbers guy and that has always made the most sense to me. I’m not too worried about variable rates because things aren’t improving quickly. The fed has anticipated mid 2015 as the earliest but I think it’ll be longer than that. If the 40 billion dollars they are pouring in monthly were going into my pocket and yours, maybe crazy amounts of inflation would occur and drastically increasing interest rates would be the solution BUT most of the money will be unseen for you and me.

    Also, I’m confident President Obama will win this election. Over the next 4 years, do you think he will let interest rates rise on student loans? I don’t.

  20. Harry @ PF Pro says:

    Wow, I hate the damn snowball method!  Haha who cares about your mental state of being and how good it will feel to pay off a loan..

    Pay off the highest loan first and save yourself some money.  Another good test is would you go for a 7/1 ARM or a 30 year fixed mortgage right now?  Kind of a similar situation to what you have.  I went with a 7/1 ARM b/c why would I pay more than I have to?  Have you seen many positive economic signs of recovery??

  21. I’d follow Justin’s advice, split the extra payments among all loans. The interest rates are all low considering they are student loans and you wouldn’t be losing much on a hedge. You can readjust in the future according to Flexo.

  22. The whole point of the snowball method is it’s the most motivating to the most people. Most people, not all people. If paying off the highest rate will motivate you more then I would do that, if knocking out the small one first would get you fired up then do that one first. Don’t most variable loans have a cap on rate and rate of increase anyway? That should give you an idea where they could go in the future.

    I personally fall in the “most people” category and paid off all my debts smallest to largest, fortunately the largest was a 0% loan (see the link below the comment) but even if it weren’t I still would have done the same thing.

    Either way you do it you’ll be happy you did. It was such a feeling of relief to write that last loan payment check. Almost as exciting as getting married :)

  23. I’d pick the 6.8% loan with the smallest balance and work on it. I personally think interest rates will stay low for the next few years. But after you pay off the smallest 6.8% loan you’ll have more “extra” money to pay on a variable rate loan if rates do rise quickly.

  24. Kevin @ Savvy on Credit says:

    Why is nobody asking about the length of the loans? Periodic interest rates are very deceiving and mask the true cost of debt.

    Look at the amortization schedules of any installment loan to find a shocking result – most of the interest accrues at the beginning – and the longer the term on the loan the greater is this skewing of amortized interest.

    I would pick the loan that applies the highest percentage of my payment to retiring the interest. This is sometimes the loan with the highest interest, but more frequently the loan with the longest term.

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