How to pay off the student loans and keep my sanity at the same time
Trent at The Simple Dollar posted today about choosing to pay off his student loans before doing significant investing. The part that intrigued me was his method of paying off the loans, which he called the “savings account method”. He puts the money earmarked to pay down his student loans above the minimum monthly payment into a high yield savings account, and then when the amount in the account is more than the remaining balance of the loan, he pays off the remainder of the loan at once.
This idea intrigued me for a number of reasons. First, Sallie Mae (my loan holder) makes it a huge pain in the behind to pay extra towards principal on your loan. I can’t just make an additional online payment (or increase my monthly online payment) because they will just apply that to my next payment due and advance my next payment date instead of applying it to the principal balance. As far as I can tell from my research into this thus far, I am going to have to physically write them a separate check that states “Apply to Principal” in the memo line every time I make an additional payment. Second, I can’t make multiple small random “snowflaking” payments every month like I do to my credit card, and I have found that this method (of paying snowflakes to debt immediately upon earning them) has really worked the best for me in terms of keeping up motivation and also the amount that gets paid to debt in a month. If I was saving the money in a savings account, I could transfer the snowflakes into that account as often as I like.
These two reasons are enough for me to give the idea serious consideration. However, what’s the cost? Not directly paying down the loan as fast as possible will mean it accrues more interest while I am building up the payoff balance in our savings account. I tried to directly calculate the total difference but there were so many variables and points to consider I couldn’t manage to do it (yet). But I did figure out a few things (just looking at my spouse’s student loan, which would be the first one we would pay off):
Using this “savings account” method, it will take an additional 1 to 2 months (excluding savings account interest, just flat on what I deposit to said account) to pay off the student loan balance on my spouse’s loan. I tried a lot of different calculations to determine exactly how much more interest I would actually pay, starting at the time the student loan debt becomes the snowballing target until it is paid off, and honestly, I pretty much failed miserably. I’m going to work on it some more. But as a rough idea, if it takes me 2 extra months to pay it off and a month’s minimum payment is $237.59, then two payments is $475.18 and that’d be how much more my loan became over that time… I think. There’s probably some internal fallacy with that idea.
There are a number of other factors that come into play in looking at the whole picture though:
-the interest the money in the savings account earned
-the tax deduction of the additional student loan interest that accrues
-paying taxes on the interest in the savings account
Just for information, the time I calculated the savings account to meet the remainder due on the loan once it becomes the snowflaking target is 16 months. We pay 9% APR (so 9.42% APY) interest on the student loan. So if we put the money instead on a savings account earning 5% (APY) interest there’s a difference in interest paid vs interest earned of 4.42%. I’m not sure what to do with that information yet, or how exactly to factor in the whole tax idea. I tried to do a bunch of things with those numbers and I ran away screaming “Noooooooo why am I not an accountant???”. 
The only reason I could convert APR to APY is using another post of Trent’s where he step by step converts them.
Anyway. The takeaway of this whole exercise is that in a short time period at least, I think that this method of putting the extra payments and snowflakes in a savings account and paying the loan in one fell swoop might really work for me. I think the actual cost to me in terms of extra interest paid, once offset by the mitigating factors of taxes and interest earned, might be negligible enough to avoid the hassle of trying to deal with Sallie Mae. I would also get to keep up my mini-micro-constant-snowflake method that really is working well for me on a psychological level by snowflaking it all to a savings account. And, I didn’t even start to factor in the cost of all the extra stamps and the paper checks.
I learn so much from the personal finance blogosphere. Now if only I could get started on that pesky student loan right this second…. patience. I’m learning.
~J
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August 9th, 2007 at 6:13 pm
Hello. The “apply to principal” note is not uncommon and, if the loan works as you describe here, the simple solution is to add 3 words to your checks (unless you want to be on the losing end of a borrow-to-invest scheme).
August 9th, 2007 at 6:29 pm
I don’t write checks. That’s the issue ;). I pay online. I’ve tried paying more than my minimum payment online before and they have invariably applied the extra to my next payment and not to principal. Both when I did it through their website and through my bank. No matter what notes I tried to attach to my online payment.
I’d have to send them paper checks. $0.41 a pop and counting plus the cost of me buying more checks
I’m sure it is going to cost me something overall my question is how much it is going to cost me. Aggravation has a price tag.
August 9th, 2007 at 7:07 pm
We do not know your balance or your extra-payment/mo amounts. You want to keep unspent cash in a high-yield account anyway but, given that, and assuming that your current installments are mostly interest, the most expensive method is making no extra payment until you have the full balance, the next best method is making extra payments on the advance-to-the-next-payment method that the lender did so far, and the best method is to get the lender to apply all the extra payment amounts to principal (you can pay up to $1k with a $1.50 postal money order plus $0.41 stamp once a month or two if that “hard” method will apply to principal only).
August 9th, 2007 at 9:07 pm
The actual amount is around $12,600 for the loan I was talking about in this post, and $12,100 for the other one in line after it. The payments on that first loan are actually not mostly going to interest, a good bit goes to principal every month (min payment is about $240 a month) because the loan has been in repayment since 1998 (started at almost $20,000).
It is all hypothetical right now anyway because the credit card is getting all the extra money.
Thanks for your input! Gives me more to think about before we go into dedicated repayment mode with that loan. Who knows what I’ll decide by then (it is about a year off at this point).