Student Loans or Credit Card Debt—Which Do I Pay Off First?

Hi Pete,

I have credit card debt of $5,300 (between two cards), but I have $6,000 of student loan money in an account earning 1 percent. More loan money, roughly $10,000, is on the way next semester.

I'm working and bringing home $1,000 a month, which takes care of rent, living expenses, and the four semesters it takes to get my Masters in Elementary Education.

Do I use the money to pay down the credit card debt or do I pay it off? Or do I leave the money in the account and add to it and earn some money, while trying to pay as I go for my remaining semesters and send the loan money back? I appreciate an impartial ear on the subject. Please and thank you! — Ken

Ken,

I’ve fallen in love with questions like this. It’s wrought with danger, options, and a little bit of intrigue — interest if you will.

Since you will be charged with educating the youth of America, I have chosen to turn your question into a good old-fashioned story problem.

Ken leaves Boston for New York City at 2 p.m. in a car traveling 60 mph. Ken has borrowed $16,000 which is earning 1 percent interest, netting him $160 per year. But what Ken doesn’t know is that he’s being charged $1,216 per year in interest on the $16,000. How mad will Ken be when he arrives in New York at 6 p.m. deeper in debt than he ever imagined?

I’m kidding, of course. It will take much longer than four hours to get to Manhattan from Boston if you leave at 2 p.m.

If you borrowed money via the Grad PLUS program, which it sounds like you did, you don’t need to make loan payments while you’re at least a half-time student and for six months after you graduate (or drop below half-time enrollment). But there’s a catch. And by catch, I mean a giant problem. You’re being charged interest, even though none of your payments are due. The current Grad PLUS loan rate is 7.6 percent. This goes for the loan money you borrowed to pay your tuition, as well as the money you’re holding in your bank account.

As soon as you graduate, all the interest capitalizes into the loans, driving your balance substantially higher. So, while you thought you were dominating a game of checkers, you just heard someone scream checkmate.

I’ve been there. I’ve also been distracted by something like credit card interest and the possibility of getting over on lenders. But whether you’re borrowing money for school, a new home, or an electric pogo stick sharing startup, you must take time to learn the terms of your loan.

The $6,000 you have and the $10,000 that’s on the way are called refunds. It’s the difference between what you borrowed and what was paid directly to the school for tuition. You’re only the 50 millionth person to think it’s a good idea to hold onto the refund, so don’t feel bad.

I know it feels like I’ve spent our entire time together telling you that you’re wrong, but you’re doing at least one thing very right. Supporting yourself with work income is a great way to decrease the amount of loans you need to take on to complete your grad degree. Most people I come across don’t make that effort.

Your email makes it sound as though you’re paying for school with your work income, thus you’re borrowing money for living expenses — expenses which you’re already covering with work income. That wouldn’t be a terrible idea if you don’t possess an emergency fund. But given you have over five grand in credit card debt, it seems like you definitely didn’t have an emergency fund. So, what now?

You have three major problems which need to be addressed: credit card debt, student loans costing you interest, and a lack of an emergency fund. You realize these are your problems, and you’re trying to leverage the problems against each other to solve the problems. Stop doing that.

First, pay back the student loans immediately. They’re complicating your financial life, and it’s an expensive backup plan. Next, put together a budget which will allow you to save an emergency fund from scratch. I know you’re living lean, but a lack of an emergency fund is what caused all these other issues.

Once you’ve put together $1,000 to $1,500 of an emergency fund, turn your attention back to the credit card debt. Use the budget you created to pay as much as you can toward that debt until it has a zero balance.

My plan is not interesting. It’s not cute. In fact, it’s simple in theory, yet difficult to execute. But mastering this notion is crucial. As you will notice throughout your life, that’s the secret recipe for financial success.

Have a question for Pete the Planner? Email him at AskPete@petetheplanner.com or visit petetheplanner.com.

This article is published courtesy of The Indianapolis Star.