In this episode, I show that Max can save a substantial amount of money by paying down his student loans early to avoid interest expenses. His $26k loan will ultimately cost him $35.9k if he makes the standard $300 monthly payments over the 10-year term of the loan because the interest at 6.8% comes to $9.9k.
My finance profs would kill me for saying this, but there’s really no need to understand the math behind this thanks to the internet. The interest component of each of Max’s monthly student loans can be determined by heading here to view his loan amortization schedule. A loan amortization schedule shows how much each of Max’s $300 monthly payment on his 10-year $26k @ 6.8% loan is comprised of interest versus principal.
I like to think of the loan amortization schedule as a sort of prison sentence. It explains exactly how much time Max is going to serve paying off the principal and interest components of his loan and how much extra he has to pay per month to get out of prison early for good behavior.
Principal is the amount Max borrowed when he went to school; it’s the $26k. This is the “meat” of his student loans. Paying down principal is good because it reduces his loan amount.
Interest is, simplistically, the profit the bank makes on Max’s loans. It’s the fat of the loan. Paying off interest occurs as a function of how long Max stretches out his loan payments. If he make the standard $3oo monthly payments versus making extra payments, he’s increasing the amount of interest he pays.
If Max makes the standard 12 monthly payments of $300 in Year 1, he’ll pay $3,600, but he’ll pay down only $1,880 of his $26k loan and he’ll pay a whopping $1,710 in interest. That’s a lot of fat! These figures are based based on the rate at which his loan amortizes, or is reduced. If, however, on Day 1 of Year 1 he pays $1,880, he will completely save the $1,710 interest expense. Because he attacked all of that meat on Day 1 instead of stretching it out over 365 days, he saves $1,710. So his $9.9k of interest due goes down by $1.7k to to ~$8.2k. In prison terms, he’s being rewarded and getting time off of his sentence for good behavior.
Some people are paying off their loans so slowly–even less than the standard payment rate, which in Max’s case is $300–that they’re paying only the interest portion of their loan or less. This is a bad situation because they’re not attacking their principal, the meat of their loan, which means they’ll never pay off their loan. They’ll continue to serve the prison sentence indefinitely because of “bad behavior.” The only way to pay off a loan is to pay off the principal.
When Max starts paying down his loans at the standard rate, almost half of his $300 monthly payment will go towards interest and the balance will go to principal. This explains why I still owed $91k of principal after I paid $20k of my $101k of student debt principal in two years at the standard repayment rate. It was only when I got serious about punching my debt in the face and made some extra payments that I paid it off early and saved $30k of interest.
At a standard payment rate, the bank is guaranteed to make all of their profit, via interest, before Max pays off the entire principal.
So, Max’s key to speeding up his debt pay-down timeline is to maximize principal payments and minimize interest payments. The only way to maximize principal payments is to make extra payments because extra payments go straight to principal. Tactically, this means Max would pay $300 when it’s due. Some will go to principal and some will go to interest. Anything else he pays along with the $300 will eliminate principal, thereby reducing the amount he’ll ultimately pay in interest.
There are lots of ways Max can make extra payments on his loans, and we’ll explore this in future episodes. In short, he can either cut back his spending in other areas of his life and put those savings towards the principal, or he can make more money and put that extra money towards his loans, or he can do what I did and do both for a combo knock-out move.
As we go through future episodes, we’ll keep tabs on Max’s prison sentence to understand how his extra payments are reducing his prison sentence.
If any of this is confusing to read, check out the vid–hopefully that helps. And if it doesn’t, feel free to ask questions in the comments section.
Reminder: For best results, view this clip in full screen and set the resolution to 1080p.
Episode 3 Materials