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Paying Off Fixed vs. Variable Interest Debt

Written by Nickel - 27 Comments

A reader named Milan recently wrote in with the following question:

Here’s my situation:

Parent PLUS Loan – $9,892 @ 7.75% APR (fixed)
Stafford Loan – $14,252 @ 4.00% APR (fixed)
Private Loan – $24,357 @ 7.72% APR (variable)

I have $10k right now that I can dump into one of these loans. Do I dump the $10k in the Parent Plus loan, and then snowball the amount I was paying on that loan into my private loan?

Advice appreciated!

This is a great question. The Parent PLUS loan has a very slightly higher interest rate as compared to the private loan. However, the Parent PLUS interest rate is fixed, whereas the private loan has a variable rate. The other thing to consider here is that the $10k lump sum is just enough to kill off the Parent PLUS loan, whereas it would only knock the private loan down by about 40%.

Looking just at the interest rates, I’d be inclined to attack that variable rate loan first — it’s on par with the Parent PLUS loan, but you have significant upside risk. Given the current state of affairs, rates really can’t do anything other than climb (though it may be awhile before that happens). That being said, there’s definitely something attractive about killing off that Parent PLUS loan first.

Debt reduction guru Dave Ramsey would most likely say to go after them in reverse order of the balances, targeting the Parent PLUS loan, followed by the Stafford loan, and finally the private loan. But if it were me, I’d probably do exactly what Milan is suggesting — pay off the Parent PLUS loan first, then snowball the payments into that variable rate private loan, saving the 4.00% APR fixed rate Stafford loan for last.

What would you guys do if you were in his shoes?

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Published on October 28th, 2008 - 27 Comments
Filed under: Debt Reduction

About the author: Nickel is the founder and editor-in-chief of this site. He's a thirty-something family man who has been writing about personal finance since 2005, and guess what? He's on Twitter!

27 Responses to “Paying Off Fixed vs. Variable Interest Debt”

1
RDS Says:
October 28th, 2008 at 6:51 am
This is a great question. First of all, congratulations for taking on this debt. That 10k will go along way towards whittling down your debt. Keep in mind that as long as your are paying off debt, you really can’t go wrong.

Personally, I would want to knock out the ParentPLUS loan. It has the highest interest rate and it should be really satisfying to completely eliminate one of your debts. Interest rates are low now – so there is more risk with the variable rate loan. But just I can’t imagine rates going up anytime soon given the state of our economy.

I would also suggest that you consider establishing an emergency fund separate from your main checking account if you have not already done so. Paying off debt is fantastic and you want to make sure that even if you hit a bump in the road, you won’t need to take on debt again.
2
Blaine Moore Says:
October 28th, 2008 at 7:48 am
While I’d normally be inclined to get rid of the risk of the variable rate loan, having one less payment on top of it being the highest rate right now means that I’d knock out the Parent PLUS first. That’s one less bill that you then have to worry about forgetting to pay on time. (This is assuming that you already have your emergency fund established, as mentioned by RDS.)
3
Daniel Says:
October 28th, 2008 at 8:36 am
I’m with Dave Ramsey on this one. Take that $10k and pay off the one loan, then attack the other two in order of smallest balance to largest balance.
4
Milan Says:
October 28th, 2008 at 8:46 am
Thanks everyone, I think I’ll take care of that parent plus loan!
5
Andy @ Retire at 40 Says:
October 28th, 2008 at 8:51 am
Taking out that Parent Plus loan in one fell swoop with give you two things:

1) Complete elimination (annihilation?) of one out of three loans

2) Massive satisfaction of paying off one of your debts

Hope it all goes well and good luck.
6
Brack Says:
October 28th, 2008 at 9:21 am
The reason you pay smallest to largest under Dave Ramsey’s plan is so that you can build up momentum. If you go a long time without making any progress, you will get discouraged and your chances with continuing to pay debt down will lessen. So I think the key is to pay off what will have the most effect on your momentum, rather than just following a recipe of dealing with the smallest to largest…

For instance, I put a lump sum against a credit card with a very high balance, which cut my monthly payment, and made the debt more manageable. By doing that, I was able to ramp up the payment on my smallest debt, and no longer had quite the mountain to climb once I got to it, so the emotion associated with it made it seem that I’d really paid off more than if I’d just paid off the small balance credit card.

I hope that made sense…
7
Oblivious Investor Says:
October 28th, 2008 at 9:42 am
If it were me, no question. I’d go after the variable rate loan first.
8
g Says:
October 28th, 2008 at 11:08 am
The two most reasonable choices are to either pay off the ParentPlus loan completely (and ’snowballing’ the extra monthly money into the Private loan – not the Stafford, which is similar to the Ramsey method) or take a big chunk out of the Private Loan – because the risk of higher rates in the future. Both of the above choices would be great and should be free of criticism.

One thing to consider: It sounds like you’re a Ramsey listener/follower (and that is great, there is nothing wrong with him/his approach – I frequently listen to him too) and his ’snowball’ approach is definitely the best approach for those who need the ‘psychological boost’ when even small debts are eliminated (and likely the people who get into bad debt situations, typically from credit cards and NOT student loans, need the ‘psychological boost’ to keep them committed). If you need the ‘boost’ to keep you committed, PAYOFF THE PARENTPLUS COMPLETELY.

However, if you are rationally committed to debt-elimination and think you can stay committed until success, than you attack the debt with the highest (or highest potential – i.e. variable) interest rate first (and don’t forget to ’snowball’ money once a debt is paid off – ala Ramsey). If you fit this category, TAKE A BIG CHUNK OUT OF THE PRIVATE LOAN.

Also, look into consolidation of (at least) the ParentPlus and Private Loan, you may be able to get a lower, fixed rate. If you can consolidate, don’t forget to keep making the same montly payment amount as the two original loans combined – use consolidation to only lower your interest rate, not to lower your monthly payment.
9
Big Cajun Man Says:
October 28th, 2008 at 12:13 pm
I think your idea of killing variable rate first is a good idea, since rates are low now, but may not stay that way (unless the fixed rate was ludicrously high, which it isn’t), so I agree with you.

C8j
10
Dave Farquhar Says:
October 28th, 2008 at 12:56 pm
I like the idea of paying off the ParentPLUS loan first, and trying to consolidate the other two to get a better rate, then snowballing that remaining loan to get rid of it as quickly as possible.

The nice thing about problems like this is that it’s hard to be wrong. When I looked at my debt and tried to figure out the optimal order to pay it off, the difference between the best and worst order was about a month. Even making the worst of the three possible choices will still save you thousands of dollars.
11
Miss m Says:
October 28th, 2008 at 2:17 pm
Since you could completely pay off the one loan I would do that, then apply the monthly payment you had on that load towards the private variable rate loan. Yes the old snowball method. Two monthly obligations are better than 3.
12
Kevin @ The Money Hawk Says:
October 28th, 2008 at 3:32 pm
Pay off the smallest first. That will allow you to cash flow more into the other debts. Just go in order and you’ll be fine.
13
Nick Says:
October 28th, 2008 at 4:40 pm
Personally as a student, I’d pay off the private loan first. It has a variable rate, and who knows what it could do. Probably not anything soon, but before it’s all paid off it might take a hike. This is with all the mental aspects aside (one less bill to pay, momentum, etc.), you just have to get past all that.
14
Kym Says:
October 28th, 2008 at 5:21 pm
Actually, you might find your variable rate loan resetting lower than it was. That is what my variable rate student loans did recently. Just like the APR on your savings account went down, so do the variable APRs on your loans.
15
ajc Says:
October 28th, 2008 at 6:34 pm
Whichever way you ’snowball’ you would certainly NEVER (*) pay off the Stafford Loan; instead – if you want to get rich(er) quick(er) – you would apply the payments that you USED to make to an investment property IF you can find a deposit (or a partner): a 4% fixed loan is too good to give up.

* Never means, unless:

1. You cannot find the means to invest in your future, or

2. You retire (which is a sensible time to aim to become debt free), or

3. The terms of the Stafford loan change or you are required to pay it back.
16
oslo Says:
October 28th, 2008 at 7:12 pm
Definitely pay the ParentPLUS loan first. As many others have mentioned – you can then snowball payments.

Pay the Stafford loan next – it has a higher risk since it is not bankruptable.

Save the private loan for last – assuming that it’s not collateralized by anything. Consider refinancing to fix the interest rate- but not into a student loan for the reasons above.

This plan may be the safest if the economic conditions worsen!
17
Joe Bleaux Says:
October 29th, 2008 at 6:32 am
Actually, because of the recession, the Fed has been cutting interest rates, causing the Prime rate to decrease. Interest rates generally decrease during recessions because the demand for credit drops. Of course I don’t know the base of the variable rate – it could be something other than Fed Funds or Prime – but in the short-to-medium term rates are headed down.

Pay off the highest interest rate first.
18
Pamela Says:
October 29th, 2008 at 12:15 pm
Personally, I would pay off the ParentPLUS loan, because it would be done, because it has the highest interest, and because presumably it is on your parent’s credit record, so as a responsible adult you would want all of your debt to be purely yours.

However, a lot of people have mentioned the risk of the variable rate. Can you consolidate that loan? All of my variable rate loans my friends had, they consolidated, most into the federal consolidation program, which fixes the rate at whatever it was when you did the consolidation. Then, you wouldn’t have the market risk anymore. Just a thought.
19
Trav Says:
October 29th, 2008 at 12:27 pm
There seems to be an assumption here that there’s a difference, even a slight one, between a 7.75% rate and a 7.72% rate. Please. I think Taleb would call this a “ludic fallacy”.

The 0.03% difference on the $10,000 loan isn’t even enough to pay for its postage stamp every month.

Just wanted to simplify things a bit. The responses here are otherwise smart and worthy advice.
20
nickel Says:
October 29th, 2008 at 12:56 pm
Trav, while the difference between 7.75% and 7.72% is miniscule, one of those is fixed and the other is variable. Thus, there’s still a big difference between the loans. To me, the 7.72% is a much worse loan despite it’s very slightly lower rate because it’s variable. While it could go down, it could also go up. That being said, I’d probably still lean toward killing off the Parent PLUS loan first just to simplify the situation.
21
Rick Says:
October 29th, 2008 at 4:09 pm
Personally, I think two bits of information are helpful to form a conclusion. First, what is the variable rate tied to? Libor? Prime Rate? The whims of the lender? I agree with some of the others that interest rates probably won’t be going up in the near future. Second, how fast do you think you’ll finish paying off these two loans? If within the next 2-3 years, then don’t even worry about it. Pay off the PLUS loan. If longer, then we can imagine rates might begin to rise, and paying off the private loans may be a better deal.

Finally, the PLUS loans are in your parents’ names, right? It *may* be a better option to pay off the private loans first, and try to improve your credit score, while allowing your parents to take the hit for having the PLUS loans in their name. (I’m not saying to be late with the payments, just let the installment loan sit on their profile, rather than yours). But I think this may or may not matter, depending on other factors on both your credit reports.
22
Milan Says:
October 29th, 2008 at 4:17 pm
Just to clarify, my private loan is dependent on the LIBOR
23
djmike805 Says:
October 30th, 2008 at 10:17 pm
Wipe out the Parent PLUS loan, you immediately wipe out $68.93 a month in interest. Do the math…
24
Steve Says:
October 31st, 2008 at 4:17 pm
If this was based on prime, I wouldn’t worry about the private loan, as I don’t think prime is going to change anytime soon. In fact, I wouldn’t be surprised if prime eventually went down to 3 (the lowest point possible). I wouldn’t count on it, but it is possible.

However, with it being tied to the LIBOR, it is a bit more risky, as the LIBOR is determined on what banks lend to each other. Until this crisis goes away, that LIBOR rate could fluctuate wildly. I would go against the grain and put it against the variable rate, as a 2 point change in that rate (which is very likely) would make a significant change to your payment, making it harder to pay off the fixed rates, which will not change.

So, if it were me, I would throw as much in as possible to the personal loan.

Another thing to check on is to make sure that neither of the other two loans are negatively amortizing. Some student loan funds make the minimum payment less than the interest owed. If that is the case, make sure you are at least covering the interest every month on the other two loans.
25
Nabloid.com Says:
November 1st, 2008 at 5:59 pm
Purely for piece of mind, I’d pay off the variable rate first. We may have a few more years of low interest rates – but I do see inflation eventually hitting and the interest rates will ramp up. That said, I do see the benefit in getting rid of that one debt altogether and then using all resources to focus on the variable. I’d still go for variable first though.
26
Swiss Cheese Says:
March 31st, 2009 at 1:14 am
Go on a holiday. Even better – find a way of leaving this miserable country and not coming back so that your repayments can be reduced dramatically (to zero).
27
Baldy Locks Says:
February 1st, 2013 at 6:54 am
Pay off one debt, balance transfer the other two debts into a lower interest deal, then snowball like an SOB.

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