Debt can be overwhelming. Particularly when you have multiple different loans. The preceding posts showed how to put debt into perspective and how to balance the competing priorities to pay debt vs invest. A high level plan may even use tax-advantaged accounts to do both. Regardless, you also need to make a concrete debt repayment plan to repay your loans. Learn how to organize your debt and eliminate it. There is also a link to calculator that I made to help.
Loans With Interest Relief or Debt Forgiveness
Some debt will have the potential for interest relief or even forgiveness. For example, as a resident, you may be eligible for interest relief in Ontario. The Federal student loans and many of the other provincial student loans are now interest-free. Period. That is a huge bonus compared to the past. Put repaying those loans lower on your repayment priority list. Focus on your other interest-generating loans.
Those planning to practice in an underserviced area may even be able to get loan forgiveness as part of a return of service contract. The Federal loan forgiveness scheme is $8K/yr for a max of five years and will soon be increased. Some provinces also have loan forgiveness programs attached to return of service, staying in province, or simply drawing breath. I embedded links to these programmes in my debt repayment plan calculator.
These programs only apply to Federal student loans and some provinces have followed suit. Importantly, they do not apply to lines of credit or other loans that you may have taken on. So, if you are planning to use interest relief or forgiveness programs, you may not want to consolidate them to your line of credit.
Consolidating Loans to a Lower Rate
You can pay less interest and eliminate your debt more quickly if you consolidate your loans to the lowest possible rate. The lowest possible rate is usually a mortgage. However, mortgages also have much less flexibility for repayment and require a property as collateral. A home equity line of credit offers more flexibility than a mortgage, but will be at a slightly higher interest rate.
Some professionals (particularly physicians) can get a personal line of credit at a good interest rate without collateral property, given their stable high income. For example, medical student or physician lines of credit are usually at the prime lending rate minus 0.25%.
Consolidating loans may not only help you to pay less interest, it is also simpler to track and pay one loan instead of many. However, it is vital to not take on new loans that replace the ones that you just consolidated!
Credit Card & Car Loans or Financing
These types of consumer debts are usually subject to very high interest rates. So, it is usually a no-brainer to pay them off using a line of credit, if you have one.
If your car loan was done via financing at the dealership, then you should be aware of a couple of possible wrinkles. Some financing will have the interest portion paid upfront. So, paying the loan back more quickly does not decrease the total interest paid over the life of the loan. Other financing arrangements may have limits on repayment or penalties for early repayment that nullify most of the benefit. Be sure to read the fine print.
Government Student Loans
Federal and provincial student loans used to be at a much higher interest rate than a professional line of credit. Fortunately, now the Federal and many provincial loans are interest free. The default repayment period is 114 months. However, you can change that online to 174 months (14.5 years) to reduce monthly payments. For the interest-free loans, that could improve cashflow to focus on your other loans. For those facing provincial interest rates (AB, ON, PQ, SK, and possibly NS), you can specify to make extra payments only to the provincial part of your loan. However, it requires you to phone them.
The other consideration for student loans is that you get a tax credit on the interest paid. The exact amount varies by province, but is about 20% of the interest paid. You do not get the tax credit for a line of credit. So, the interest rate of your line of credit would need to be about 20% less than the rate of your student loan to be worth consolidating. You can use my student loan calculator to see the effective interest rate that a Iine of credit would need to beat the government student loan. It is also factored into the student loan section of my larger Debt Garburator debt repayment plan calculator.
Debt Repayment Strategies
Once you have prioritized to take advantage of debt relief and consolidate loans as much as possible, you are left with how to prioritize paying it all off. You likely have minimum payments to make for each loan. However, minimum payments are meant to maximize the interest that you pay to the lender while still eventually paying the money back. Not to give you more money to spend. Your debt is income that you have already spent.
Changes in Spending & Income
To eliminate debt in a timely fashion, you must control your spending and focus excess earnings on your debt. Use strategies to savor your spending and spend in the ways that are most likely to bring you more happiness return. That doesn’t need to be masochistic or expensive.
As you have increases in your income, do not immediately inflate your lifestyle to match it. You may get a nasty surprise when you realize that you have less after-tax income than you thought. To eliminate debt the quickest, put all raises towards debt repayment. If that is psychologically detrimental to you, then put a portion towards your debt. Just be sure to do that first, before it is left vulnerable to be spent.
Sequence of Loan Repayment
There are three main approaches to repayment sequence. One is to simply spread out extra payments across all of your debts. Few people to do that because it is neither motivating nor mathematically optimal.
The two main approaches are colloquially called the Snowball and the Avalanche methods. Both target one loan at a time to eliminate it. Focus is good for follow-through. The freed up cashflow is then added to more debt repayment. That is key – do not use the freed up cashflow to add to your action figure collection expansion instead.
The Snowball vs Avalanche Strategies For Loan Repayment
The snowball strategy focuses on loan size and the avalanche strategy focus on interest rates. Both approaches accelerate the rate of debt repayment as freed up cashflow is kept focused on trashing the debt. However, the snowball method may have a behavioral advantage and the avalanche a mathematical one. Honestly consider which matters more for your psychology and circumstance. Not only will psychology impact your success, successfully eliminating debt can improve your mental health in return.
Building a Debt Repayment Snowball
The snowball strategy for debt repayment focuses paying the smallest debt first. Regardless of interest rate. As you free up cashflow by knocking off a debt, you add to the amount you pay each month. That grows into a larger and larger payments as you tackle progressively larger debts.
The strength of this method is that you can see debts being eliminated more quickly. That is less overwhelming and more motivating. The behavioural psychology is very important. Many people need to get frequent rewards to stick with difficult tasks for longer term succeed. Particularly, when the newest Mandalorian action figure beckons.
The downside of the snowball method is that it may not be mathematically optimal. You may have a larger debt at a higher interest rate that will keep growing faster while you are focused on smaller debts. Fortunately, in reality it is quite common for the largest debts to also have lower interest rates (eg a mortgage or professional line of credit).
Starting a Debt Repayment Avalanche
The avalanche strategy for debt repayment focuses on paying the highest interest debt first. Regardless of size. As you free up cashflow by paying off debts, it is added to the loan payments. The rate at which you pay off principal accelerates like an avalanche as you decrease the interest paid each month.
This is the mathematically optimal strategy. The potential downside is if you have a hard time getting and staying motivated. It may take time and sustained effort if you have a large high-interest loan as part of your debt mix.
Dirt in the snow.
There are a few nuances that influence both of the above approaches.
First, if you have a student loan with no interest, there is really no rush to pay it off regardless of size. In fact, I would try to stretch out repayment as long as possible. It makes more sense to redirect cashflow to other debt.
Even, if my other debt were paid off, it is money that I could invest instead. It is pretty easy to beat 0%/yr returns. Further, if my wages increase over time, the debt is priced in nominal dollars. So, it takes progressively less work to pay the loan down as time passes. All that to say that I would exclude interest-free loans, if using the snowball strategy.
Second, I do not want to miss out on loan forgiveness. If I am in line for that, then I would not pay down my debt faster than I must if it means losing that money. However, some provincial loans are subject to interest and may have forgiveness. In that case, I would pay down the loan to a level just above the forgiveness. The priority of doing that would still depend on whether I am using a snowball or avalanche approach.
Even if I am prioritizing a loan based on its size or interest rate, there may be limits to how much I can pay in a year. For example, you may be capped at 10-20% pre-payment per year on a mortgage. You may have the option to increase mortgage payments by 10-20%/yr each year. That may change how fast you can repay the debt regardless of method.
The Debt Garburator – Plan to Trash Your Debt
This is the most important thing. Little optimizations are less important than knowing what your debt load is and prioritizing money to repay it. Don’t give in to paralysis by analysis. Similarly, do not waste time and energy beating yourself up over how the debt got there, be financially self-compassionate, and move forward.
To help with the mathematical optimization, inspire you with a chart/table, and produce printable payment schedules, I made a debt repayment plan calculator. You can just enter in your debts, their characteristics, how much money you have for monthly debt repayment (plus option lump sums), and it maps it out.