You can consolidate your loans to reduce the amount you pay in interest, or you can go for a lower monthly payment.
If you ask a personal finance expert, they’ll tell you to pay as little as you can on the loan by going for a lower interest rate and/or a shorter loan term.
As an investor, I often opt to minimize my monthly payment so I can reinvest the savings and maximize my earning potential.
But how do I decide when to take which approach?
The Easy Scenario
Before we dive into comparing these two styles of loan consolidation I want to mention that there is one scenario that everyone can agree you absolutely should consolidate your loans.
If you can get the same loan term (number of years to pay it off) with a lower interest rate, do it! That’s always a good move.
Now let’s look at an example that’s less straight forward.
The Traditional View
Let’s assume you have a $30,000 loan with 6.5% interest on a 10 year term and you have the option to refinance that to a 5 year term with 3.5% interest. Like this,
Option 1 – $30,000 loan at 6.5% for 10 years
Option 2 – $30,000 loan at 3.5% for 5 years
If you consider only this information, then you will always conclude that option 2 is the better financial option.
This is because option 1 will have you paying $40,877 over the 10 year period and option 2 will have you paying only $32,745 over the 5 year period. So you save around $8,000 in interest if you go with option 2. (Numbers calculated using the Bankrate loan calculator)
Easy math, right?
When you simplify the problem in this way, it can help you make an informed decision. But you can extend the problem by asking another question.
What will I do with the money I’m saving on a lower monthly payment?
The Investor’s View
Let’s look at the same two loans and approach it a bit differently.
- $30,000 loan at 6.5% for 120 payments of $341
- $30,000 loan at 3.5% for 60 payments of $546
The difference between these two payments is $205 per month. An investor sees that $205 dollars a month and knows it can be reinvested.
After 10 years, if you reinvested all your extra money, you would be able to invest in this way:
- 120 investments of $205 over 10 years
- 60 months (5 years) with no investment, then 60 investments of $546 over 5 years.
There are lots of types of investments and let’s look at how three different types of investments might play out in this example.
Invest in Stocks
Let’s assume that you invest your extra money in stocks that average an 8% return. (Numbers calculated with the Calculator.net investment calculator)
- Your 120 investments of $205 would equal $36,925
- Nothing for 5 years then 60 investments of $546 would equal $39,828
So in this scenario, you’re still in a better situation after 10 years if you took the second loan option (5 year term at 3.5% interest).
Invest in Private Loans
Now let’s assume that you invest the extra money in private loans that yield a 15% return.
- 120 investments of $205 would equal $53,294
- Nothing for 5 years then 60 investments of $546 would equal $47,137
But let’s not forget the amount paid on those loans. Option 1 cost us an extra $8,000. So after 10 years it still looks like option 2 is slightly better.
But what if we take this example out to 12 years? Or 15 years?
After 12 years
Let’s assume you continue to contribute the $546 per month in both scenarios. (After you’ve paid off the 10 year loan, you can contribute the full $546)
Option 1 has now caught up to option 2 as an equally viable loan option since the investment has made up for the extra $8,000 paid on the loan.
After 15 years
If we continue doing this for another 3 years…
Now when you take a 15 year view you can see that option 1 becomes the superior option. It’s outperformed option 2 by about $12,500 which is more than the $8000 difference paid on the original loan.
What does it mean?
So how can we simplify this information in a meaningful way?
What it means is that over long periods of time, the investment numbers are actually more important than the debt numbers.
We can look at the debt numbers and see that one option will save money, but once the debt is paid off the amount saved will never change.
Money that’s invested will continue to grow forever as long as it remains invested.
So for our example of the two loans, whichever loan option has more money in the investment account after 10 years is actually the better long term loan option to choose!
When You Shouldn’t Consolidate Your Loans
There are plenty of times that it doesn’t make sense to consolidate your loans, either because it will be too much of a headache, or because it simply won’t make much of an improvement to your financial situation.
Simplifying Multiple Payments
One benefit we didn’t talk about is just simplifying your loan payments. Maybe you have one loan payment of $100, another for $250, another for $200 and a fourth one for $450. Maybe you can consolidate and get one payment of $1000 at the same rates and terms you currently have.
That could give you some peace of mind and just be easier to keep organized. If simplicity is appealing to you, then go ahead.
Just know that this makes no difference to your bank account, so the only reason to consolidate here is if it makes a quality of life difference.
Small Interest and Term Changes
If by consolidating or refinancing your loan terms and the interest rate won’t change very much, then I usually won’t bother.
One rule I use is looking for at least a 1% reduction to the interest rate (i.e. 5% interest to 4% interest).
You may be able to save $10/month on a $300/month payment, or save $1,000 on a loan that’s going to cost you $75,000.
My advice is wait until the market changes (or your credit score improves) and you get a change that makes a bigger difference
Looking For a New Loan
I avoid changing anything about my debt payments when I’m talking to banks about getting a new loan.
Banks are very picky about documentation of your finances and trust me, you don’t want the headache of submitting all that paperwork again when you have a change to an existing loan.
The information in this article shows the type of analysis I would do if I were asking myself if I should consolidate or refinance loans.
Most of the investments Kate and I have engaged in so far have had 15% returns or better.
For this reason, we have usually opted for loan terms that offer lower monthly payments.
However, if you have no plans to reinvest the money saved on a lower monthly payment, then it is advised to stick to the terms that have you paying the least over the life of the loan.
If you want something simple use this rule:
If you’ll reinvest savings, go for a lower monthly payment, otherwise go for the lowest total amount paid on the loan.