Which is Best: Pay Off Debts Now Or Avoid Future Ones?

Ken wrote in with an interesting question that sometimes shows that paying down debts might not be the most prudent financial move:

My girlfriend and I both went to a private college. Fortunately, my parents paid most of my tuition, but I still have $11,000 worth of loans, which I plan to pay off as quickly as possible (1-2 years). Unfortunately, my girlfriend was not so lucky. She will have about $60,000 and counting (interest) by the time we graduate. In addition, I will hopefully have a good job that pays well, so that isn’t really a concern. However, she is a music major, so she cannot really use her degree (one of those bad decisions that you only now realize, but it is already too late). She will be getting a job pretty much anywhere. I was wondering what type of repayment plan we should do.

Should we try the snowball effect with me paying off my loans first? Then taking what I would normally be paying and pay it towards her loans. In addition, every time she pays off one of her loans, snowball it into the other loans. That seems like the most logical solution.

To this point, I agree with Ken – they should be snowballing these debts. But then Ken drops a little bit more information that changes the picture:

Unfortunately, we would like to get married in a couple of years (2009), so we need to save for that and of course she needs a car when she graduates. I just was hoping that you could give me an idea if I am thinking about this correctly.

Given that they have two big expenses looming that would likely create a big crater of debt in their lives, likely both at interest rates higher than the student loans, I don’t recommend that Ken starts paying ahead on the student loans. Instead, he should make minimum payments on those and start saving very seriously for the car (until the car purchase happens) and then for the wedding. Here’s why.

First of all, most student loan debt is at a significantly lower interest rate than car loans and especially credit cards. This means that the payments will be large ($70,000+ is a lot of debt) but still manageable. Ken should do everything possible to get these loans as cheap as he can: lock in the lowest rates that he can find, then set up an automatic payment plan if it awards him or his girlfriend a reduced rate. It may only save several dollars a month, but that really builds up over time.

Secondly, with that much debt, they’re likely to not get favorable rates on their first auto loan. They should both find out their credit score and not be shocked if it’s not stellar. It’s because of this potential bad rate on the auto loan that they should save now to minimize this loan – or, even better, just pay for the car entirely. Don’t demand an expensive car; now is the time to buy a used one.

Thirdly, saving for that car will allow interest to work in your favor for a while. If Ken saves his money with HSBC Direct, he can earn a 5.05% APY over the next year as he saves for the car. This will increase the money he can put for a down payment by a few percent, thus decreasing the principal he’ll have on the car loan and thus also the interest on the car loan. This is substantially more effective than simply paying ahead on a low-interest student loan and then incurring a large car loan.

A similar philosophy is true for the wedding, which would likely be “funded” by credit card (meaning with a hefty interest rate) if he doesn’t save ahead for it. Since avoiding such debt is much more effective than paying down a low-interest loan, this is the way to go.

What about risk? Obviously, this method carries a bit of risk with it – Ken needs to have the willpower to consistently save for the car and for the wedding and not spend the money, especially when he sees the balance building up in the savings account. Ken didn’t mention any credit card debt, though, which would lead me to believe that he does understand the dangers of debt and frivolous spending.

Good luck!