It’s a great question, and while there’s no “right” answer, there is a way to think about this dilemma that we find helpful: your DTI.
Debt to Income ratio (or "DTI") is how much you owe on debt payments every month as a percentage of your monthly income. This percentage is closely tied to your personal situation, and is a key concept to get you started. DTI applies to all debt, including your student loans, car loans, and minimum credit card payments.
What’s a Good or Bad Level of Debt?
If your DTI is higher than 20-30%, consider lowering your debt obligations each month.
You can bring down your debt obligations in two ways:
- Refinance to a new loan with a longer term to lower your monthly payment.
- Refinance to a loan with a lower rate, which will offer greater savings over the life of the loan.
What's the difference between the first and second choice? It’s related to the length of your loan.
To reduce each month’s payment, choosing a longer term loan spreads out the amount you owe over the life of your loan. For instance, moving your $50,000 loan from a 10-year, 5.99% fixed rate to a 15-year, 6.49% fixed rate loan saves you nearly 22% on your payments each month.
To reduce the total amount of interest you pay over the life of the loan, choosing a shorter term loan typically comes with lower rates because this reduces risk to your lender.
Which Approach Should I Take?
Here are two examples showing how either route may make sense:
Scenario A: Longer term, lower monthly payments. You’re an entrepreneur, a small business owner, or even someone who has not yet built up an emergency fund, and you need spending flexibility in the short term. It’s okay to opt for lower monthly payments now. And you can do that by refinancing to a lower interest rate and a longer term.
Scenario B: Shorter term, lower interest paid over the life of the loan. Your goal is to save as much as possible on the total amount you will have to re-pay on your loans. You have some excess cash now—you can pre-pay your loans (i.e., pay more than your monthly bill) in order to save on interest payments in the long run (because you’re lowering the principal owed on your loan by pre-paying it early). And don’t worry about getting hit with a fee for pre-paying—it’s illegal for any lender to charge you for paying off your education loan early. By pre-paying and re-financing to a lower rate, you can save thousands on your loan payments overall.
Lowering Your Debt Obligations
You’ll hear many experts tell you to tackle whichever debt has the highest interest rate first in order to minimize how much you’re paying in interest. (If you have credit card debt with a higher rate than your student loans, for instance, get rid of that debt first before paying extra on your student loans.) And we tend to agree.