You have two relatively small student loans from two different lenders. The loans have the same principals but different interest rates:
Loan Initial balance Interest rate:
A $4,000 0.04
B $4,000 0.06
Interest accrues on the balances annually. Assume that your lenders do not require you to make a minimum payment each period. You have decided that you can afford to spend $1,000 per year to pay back these loans. Interest will begin accruing in one year. In this problem you will compare two repayment options.
(a) First, suppose that you will divide your $1,000 annual payment equally between the two loans. If one loan happens to be paid off first, then you will allocate available funds toward the remaining loan. How many years will it take for you to pay off both loans? What is the cumulative dollar value of the interest that you will end up paying to your lender?
(b) Now, suppose that you will use all available funds to payoff the higher interest loan first. Once the higher interest loan is paid off, you will then allocate all available funds to the lower interest loan. How many years will it take for you to pay both loans? What is the cumulative dollar value of the interest that you will end up paying to your lender?
(c) Based on your answers, what do you conclude about the best way to simultaneously pay back multiple loans that have different interest rates?