Pay off student loan interest before it capitalizes or credit cards?
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Anonymous
| I’m a financial dummy when it comes to understanding interest capitalization. Right now I have about $5,500 in credit card debt at 14.99%. I recently finished my Master’s degree and have about $75,000 in student loans with interest rates around 7% and an additional $5,100 in interest which will capitalize in June if I don’t pay it before then. I have $1,100 over my minimum payments each month to pay down debt. Does it make more sense to focus on the credit card interest, or should I try to pay down the student loan interest before it capitalizes? I’m not sure which would save me more money in the long run. |
Anonymous
| I'd pay 75% to pay down your student loans to avoid the extra interest capitalization, and use the rest (25%) on the higher interest CC debt. |
Anonymous
| Umm, pay down the credit card debt first because the interest rate is much higher. I don't understand why this is even a question. |
Anonymous
Because, as the OP said, she doesn't understand capitalization. It capitalization caused the loan's interest rate to change, and you could prevent it by paying only $5,000 on a $75,000 loan, it could be advantageous to do even in the face of higher interest but lower balance debt. It could also be advantageous if there were multiple capitalization points. But neither are true, OP. Adding this amount of interest to the loan balance will increase the amount of interest you pay over the life of the loan, but the change will be proportional to the higher principal payment and at the original interest rate. What this means is that you're effectively being forced to take out a new loan with a balance of $5,100 and an interest rate of 7%. That makes your analysis pretty easy: Suppose a bank offered you a $5,100 loan at 7% with no fees. In that case, you'd immediately accept it and use that money to pay down 90% of your credit card debt, right? Same analysis applies here. Pay down the credit card debt and then worry about the loan. |
Anonymous
| OP here, thanks PP for the excellent explanation! I'll focus on the credit cards first. |