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The Devil is in the Details

August 28, 2013

About a week ago I finished reading the No More Harvard Debt blog and furiously started creating pro-formas and amortization tables capable of counterfactual analysis (because I’m a nerd like that).  My first post gives some background and the 10,000 ft. view, but now I want to take a second to zoom in and look at the details.

Snowball v. Avalanche

In my first post, I talked a little bit about the snowball v. the avalanche approach to attacking debt.  A friend of mine posted a comment on my Facebook status on this, and I wanted to expand upon this topic more, since I figured others might be curious as well.

From a mathematical perspective, the avalanche approach will always, always result in the fastest payback period with the least amount of interest paid.  However, when you take into account behavioral economics and the monetary value one might place on the momentum and or motivation one derives from seeing an account closed, this difference might be negligible. On the other hand, the monetary value of momentum or motivation, may be cancelled out for some by the monetary value of the emotional distress of paying extra interest.  This might be a tad bit confusing, but my point is that the best approach to paying down debt varies by individual and to pick the appropriate approach, you really need to know yourself and what motivates you the most (i.e. seeing an account close or knowing you saved more by paying the least amount of interest).

The Plan

As I’ve mentioned before, I tend to keep a pretty close eye on our finances, so when we decided to tackle this, I had years of financial data to pull from (with literally every single thing we’ve purchased tracked for the past 5 years).  I took a budget template from No More Harvard Debt, made it pretty, and customized it for the analysis I wanted to conduct. I focused on the next ten months, which brings us to June 2014 and the end of my MBA loan grace period.

Option 1

I made a couple of assumptions in creating this pro-forma

  1. Assume there would be a post-MBA bump to my salary in one way or another. I spread this out over February – June because the timing may be uncertain.
  2. Assume that we would use half of our childcare FSA reimbursement to pay down debt and put half into savings
  3. Assume that we would not pay anything towards my student loans until the grace period ended

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One thing that will probably pop out at you is the travel/savings line item. Allow me to explain – this next year is a crazy busy one for us. One of my best friends from college is having her engagement in October (already bought tickets), and we’ve planned a trip to Orlando for 5 days between Christmas and New Years (which is why the entire FSA reimbursement we get in January is going to savings – it will cover the costs associated with it). My brother is also getting married in May (YAY!) so there will be my sister-in-law’s bridal shower, bachelorette party and of course, the wedding itself. My friend will also have her bachelorette party next year and her wedding that I wouldn’t miss for the world. When it comes down to it, paying back debt requires sacrifice, and I’m willing to sacrifice material things, but I’m not willing to sacrifice once-in-a-lifetime events for money. I can live with the regret that might come from not meeting our goal of repaying all the debt in 3 years; I cannot live with the regret that would come from missing these milestone events in the lives of our friends and family.

Once I created the pro-forma, I created amortization tables based on the outstanding loan amounts and the estimated payment we would be making each month. For this, I assumed we took a snowball approach and paid the minimum payment on all but the loan with the smallest balance. For that loan, we would pay the minimum plus whatever was in the “actual cash paid to debt” line in the pro-forma. The table I created is below:

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According to this schedule, hubby’s SL #2 (with a balance of $310) would be paid off in September; the Honda would be paid off in December, and hubby’s SL#1 would be paid off in May. Aside from my student loans, that would bring us into June with just the Highlander loan. At 0% interest, that is the one loan we will not try to pay off early, so we could instead take all the funds in the “Actual Cash Paid to Debt” line item in June and throw it at my loans, as well as any extra funds that remain in May after paying off hubby’s SL#1.

During the next 10 months, my loans will not just be sitting idle. They’ll be accruing interest. However, because I’m in deferment and enrolled in school, the interest won’t be capitalized. What that means is that instead of accruing interest on interest, my loans are only accruing interest on the principle. Here’s an interest accrual table that shows this in action for both my PLUS loans and my Federal Direct Loans:

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What this means is that if we don’t pay the interest while I’m in deferment, I’ll end up owing about $96,042. If we do pay the interest while I’m in deferment, we’ll end up owing about $91, 025.

MBA Student Loan Analysis

After taking a look at all the interest we’d accrue on my loans, I did some analysis to figure out what this meant for repayment. I looked at three scenarios:

  1. Capitalized Interest – this assumes we don’t pay any interest at all during deferment
  2. Uncapitalized interest – this assumes we pay all of the interest during deferment
  3. Hybrid interest – this assumes we pay some, but not all of the interest during deferment

Within each of these scenarios, I looked at three different options:

  1. Standard (10 year) repayment
  2. Accelerated repayment
  3. Fixed monthly payment of $3,500

Here is a summary of that analysis:

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The accelerated repayment assumes a payoff date of December 2016. I did an equal payment calculation to see what the real costs might be of allowing interest to accrue on my loans. So for the uncapitalized option compared to the capitalized option, in addition to the $5,000 savings from interest, we would also save a $3500 monthly payment since we pay off the loan in 29 months instead of 30 for a total savings of $8500.

All this got me really excited about doing some counterfactual analysis with my original budget and pro forma. This led me to create…

Option 2

In this pro-forma, I looked to see how things would work if we paid the accrued interest on both my student loans as well as how things would look if we only paid one. After reviewing the analysis above as well as the projections, the most viable option was to pay the accrued interest on one of my student loans. The pro-forma for this scenario is below:

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And here is the accompanying amortization tables for our current loans:

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In this scenario, we’d still be able to pay off all of our existing loans (except the Highlander) and we’d also be able to pay the accrued interest on my PLUS loans (which have the higher interest rate).

The Plan

Options 1 and 2 result in roughly the same dollar value being put towards my student loan interest by the end of the 10 month period. However, Option 2 has one advantage – while I’m in school, any payments I make within 120 days of a loan disbursement are treated as refunds. This results in the principle of the loan decreasing, and any interest accrued will be based on the lower balance (i.e. less interest in the future)!

Next Steps

OK – so that is a TON of information and probably data overload. Tomorrow, I’ll post about some of the risks to the plan and mitigation strategies.

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