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Graham Westmacott CFA

Portfolio Manager

Susan Daley CFA

Associate Portfolio Manager
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Debt Repayment Strategies: A Case Study

August 20, 2015 - 0 comments

Following my previous post on the fundamentals of debt, I provide a concrete example of how one can implement some of the strategies for repaying debt.

There are a few basic guidelines when it comes to paying down debt:

  1. Pay off highest interest loans first (after all minimums have been paid)
  2. Pay off the balance as soon as you have money available (i.e. it is better to pay off the loan monthly, rather than accumulate money until the end of the year and pay off a large chunk)
  3. Pay back as much as possible to reduce the time it takes to pay off the loan

I will use the following example to show the impact that these items make:

Rachel is a recent university graduate. She qualified for a partial OSAP loan for her Biology degree, but unfortunately that wasn’t enough so she needed to also acquire a student loan from her bank. After almost two years of paying off her loan, she still has $15,400.81 in OSAP loans, and a student loan from her bank (which was converted to a Line of Credit (LOC) upon graduation) has a balance of $10,104.97. Luckily, Rachel was offered a full-time position with her final co-op employer, who now pays her a $50,000 salary.

  Bank Line of Credit OSAP
Balance $10,104.97 $15,400.81
Interest Rate 4.70% 5.20%
Minimum Payment $202.10 $201.56

 

Under the above scenario, paying only the minimum payments, Rachel will incur the following total amounts on her loan:

  Total Debt Payments Interest Expense Time to Repay Both Loans
Minimum Balances Paid $30,012.99 $4,507.21 93 months

 

1. Pay off the Highest Interest Loans First

Let’s look at the first guideline above, to pay back the highest interest loan first. Normally, the OSAP loan would be paid off first, because it has a higher interest rate, 5.2%, compared to the 4.7% rate on the Line of Credit. However, there is a catch when it comes to student loans: you can claim a non-refundable tax credit on your tax return for the interest you paid on a loan received under the Canada Student Loans Act, Canada Student Financial Assistance Act, or a similar provincial/territorial government law. OSAP falls into this category. So when we compare the interest rates of the two loans, we need to compare the after-tax interest rates. The Bank’s Line of Credit does not receive a tax credit, so its rate remains at 4.7%. The OSAP loan qualifies for a 20.05% tax credit (in Ontario), so the corresponding interest rate is 4.16% (i.e. 5.20% * (1-20.05%)). Therefore, once the minimum monthly payments have been made, any additional debt repayments should go towards paying off the Line of Credit first, then the OSAP loan.

Let’s assume that Rachel is using the guidelines provided in my Budgeting post, and is putting aside 20% of her after-tax income towards debt repayment. This would mean that she is putting $8,261 yearly, or $688.42 monthly, towards her debt repayment. Since she must pay back the minimums each month, she will put $201.56 monthly payments towards her OSAP payment, and the remaining $486.86 goes towards her Line of Credit. Once the LOC has been paid off, the full $688.42 will go towards her OSAP loan.  Below is a summary of the total amounts. The second row shows the totals if she were to pay off the OSAP loan first (lower after-tax rate) and the LOC second.

  Total Debt Payments Interest Expense Time to Repay Total Loans
LOC Paid Off First $27,413.26 $2,271.61 40 months
OSAP Paid Off First $27,696.85 $2,212.58 40 months

 

Note that although the total interest expense is slightly higher when paying off the LOC first, the total personal payments are lower, because Rachel will receive higher tax credits from the government on her OSAP loan. An additional note is that within the calculations, the amount of tax credits received from the OSAP interest payments is added to the debt repayments each year. In our scenario, the total debt payments are quite similar (only $283.59 difference) when comparing paying off the OSAP loan first or the LOC first. This difference will be larger if the interest rate differential becomes wider, and the total debt balances are larger.

2. Pay off the Balance as Soon a Money Becomes Available

Next, we will look at the scenario where Rachel still puts 20% of her after-tax income towards debt repayments, but instead of paying the $688.42 monthly, she only pays the minimum balances each month and accumulates the remainder of the cash in her savings account to have a lump sum payment at the end of the year. In this scenario, Rachel will have $3,417.08 at the end of each year to put towards her debt. We ignore the impact of putting the money into a savings accounts until the end of the year. This is only a beneficial strategy if one can earn a risk-free interest rate that is higher than the rate on the loan, something that is extremely rare. Since the LOC has the higher after-tax interest rate, she will put the lump sum payment towards that until it is paid off, and will subsequently put the lump sums towards the OSAP loan.

  Total Debt Payments Interest Expense Time to Repay Total Loans
LOC Paid Off First – Yearly Payments $27,794.82 $2,696.27 48 months
LOC Paid Off First – Monthly Payments $27,413.26 $2,271.61 40 months

 

By waiting to pay off debt until Rachel has accumulated cash for a yearly lump sum payment, she delays the time to repay the loan by 8 months and increase total interest by $424.61.

3. Pay Back as Much as Possible (As Quickly As Possible)

After sitting down with Rachel and going over her budget, we determined that she could afford to pay back $1,000 of her debts each month (this equates to 29% of her after-tax income). Again, assuming that she pays back the Line of Credit First, and doesn’t delay the $1,000 monthly payment, the following totals are achieved:

  Total Debt Payments Interest Expense Time to Repay Total Loans
LOC Paid Off First - $1,000 Monthly Payments $26,791.50 $1,538.10 27 months

 

As you can see, paying back the loan with higher payments each month provides the greatest reduction in interest and overall payments towards servicing the debt and allows Rachel to pay off her debt much more quickly.

Some Notes on Government Student Loans

One might be tempted to transfer their OSAP or other student loan to a financial institution that is offering a lower interest rate (even when considering the tax credit available). While this may be a good idea in your specific situation, there are a few things to keep in mind.If you were to lose your job, become sick or injured, or cannot pay back your loans for some other reasons, you may be eligible for loan repayment assistance from the government. You will waive this possibility if you pay off your OSAP loan in full by taking on other debt. Often, very low interest rate options are available for a limited time. If you cannot pay back the loan in full within that time, interest rates can become extremely high, which would negate the reason to move the loan over in the first place.

Putting it All Together

As you can see in the table and chart below, paying off the highest interest loan first, with higher regular payments throughout the year will save you money in interest charges and help you achieve your goals faster.

  Total Debt Payments Interest Expense Time to Repay Total Loans
Minimum Balances Paid $30,012.99 $4,507.21 93 months
LOC Paid Off First – Yearly $27,794.82 $2,696.27 48 months
OSAP Paid Off First – Monthly $27,696.85 $2,212.58 40 months
LOC Paid Off First – Monthly $27,413.26 $2,271.61 40 months
LOC Paid Off First – $1,000 Monthly $26,791.50 $1,538.10 27 months

 

PWL Capital - Debt Repayment Strategies: A Case Study

Source: PWL Capital

Albert Einstein once said “Compound interest is the eighth wonder of the world. He who understands it, earns it…he who doesn’t…pays it”. By paying off your debt strategically, you can stop paying compound interest and start earning it.

By: Susan Daley with 0 comments.
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