Investment Blogs

One of my Yakezie friends Fiscal Phoenix got some advice from a financial planner about paying off debt.  The choice was between paying down student loans and paying down credit cards.  The credit cards had a lower average balance and a higher average interest rate than the student loans.  Given these pieces of information, it seems like it would make more sense to pay down the credit cards first rather than the student loans.  Right?

Her financial planner gave her the opposite advice: pay down the student loans, which had a higher balance and a lower interest rate.  The planner’s reasoning was that credit card debt can be discharged in a bankruptcy, while student loan debt cannot.

Student loans:  A great deal for everyone except the student

Who in their right mind would loan someone tens or even hundreds of thousands of dollars at low interest rates for someone to advance their education?  Banks do it with mortgages and car loans because there is collateral:  they can take your house / car back if you don’t pay.  Not so with an education.  The diploma is worthless to them.

They write student loans because some kinds are guaranteed by the government.  Then, why would the government do this?  Well, the bankruptcy rules (Section 523(a)(8)) make many student loans non-dischargeable in bankruptcy unless undue hardship can be demonstrated.  This means that the student loans stick around longer than other debts, even through they’ve bankruptcy.

It’s a virtuous circle for lenders and educational institutions:  lenders can lend with little fear of getting stiffed, educational institutions can ratchet fees several percent each year regardless of inflation, and the government backs it all.  It’s bad for students:  they’re paying (and borrowing) more and more for degrees that are worth less and less, and the student loan burden sucks the life out of their finances for years.

Why plan to fail?

Even with the risk of having the student loans stick around bankruptcy, paying down the credit cards first is better for a number of reasons:

• Paying down the lower-balance debts first gives a quicker victory.  The payment is gone after the debt is paid off, and the money is freed up to attack the other debts.
• Paying down the higher-interest-rate debts first saves interest.  The higher the interest rate, the more money saved by paying the balance off faster.
• The credit card minimum payment decreases, even with a remaining balance.  Student loans are installment loans — there’s a constant minimum payment throughout the life of the loan.  Paying down this kind of loan doesn’t reduce the monthly payment; it only reduces how long you have to make those minimum monthly payments. Credit card minimum payments, however, are usually some low minimum amount, unless the balance exceeds a certain amount, at which it become a percentage of the balance due.  So if the minimum credit card payment is, say, 4% of the balance due, then paying down a $10,000 balance to $8,000 reduces the minimum payment from $400 to $320.  This gives some extra breathing room in case something bad happens.

In short, I’d pay down the credit cards first in this case.

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