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The Hidden Costs of Paying Off Student Loans Early

Student loan prepayment comes with many advantages, but there are a few downsides that borrowers should understand.

Written By: Michael P. Lux, Esq.

Last Updated:

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The Hidden Costs of Paying Off Student Loans Early

Student loan prepayment comes with many advantages, but there are a few downsides that borrowers should understand.

Written By: Michael P. Lux, Esq.

Last Updated:

Affiliate Disclosure and Integrity Pledge

Eliminating student debt should be a priority for all borrowers. Student loans are a huge source of stress, and the interest adds up quickly.

Paying off student loans early is a worthwhile goal, but aggressive repayment comes with a cost. A singular focus on student debt can cause borrowers to miss other financial opportunities and may lead to some mistakes.

Today we will discuss ways to avoid repayment mistakes, prepayment penalties, and cover strategies to incorporate early student loan repayment with your other financial goals.

Should I worry about prepayment penalties with student debt?

The good news for student loan borrowers who are ready for aggressive debt elimination is that prepayment penalties should not be a concern.

The federal government does not charge any fees for paying off student loans early. Additionally, private student loan lenders have not been allowed to charge prepayment fees since 2008. (15 U.S.C. § 1650(e) prohibits lenders from imposing “a fee or penalty on a borrower for early repayment or prepayment of any private education loan.”)

Thus, lenders cannot penalize borrowers who want to attack their student loans.

Will delaying student loan repayment help my credit score?

Some borrowers think a hidden cost of early student loan repayment is a potential hit to your credit score.

There is some truth to this fear as some borrowers have reported that paying off a student loan caused a credit score drop. The most likely explanation is that the borrower’s oldest line of credit, the student loan, fell off their credit report.

However, even if there is a risk of a credit score drop, the concern is minimal. If the score falls, it will likely be a small change, and the score should recover fairly quickly. Look at it this way: if credit score is a measure of who is most deserving of credit, shouldn’t paying off a loan help the score?

Ultimately, paying extra money to artificially inflate a credit score rarely makes sense. Spending extra on student loan interest just for bragging rights on a credit report is a waste.

Borrowers who are looking to buy a house and worried that a small drop in credit score might be costly should contact their mortgage company or a mortgage broker. In some cases, paying off the student loan might be helpful. Other times, the mortgage expert might suggest waiting to pay off the loan until the mortgage is final.

Will I miss out on a student loan tax deduction?

Some borrowers choose to delay eliminating their student loans because they get a tax break.

This is a terrible idea. The deduction applies only to some student loan interest paid, and it is a really weak tax break.

Many borrowers will not even qualify for the tax break, and those that do will hardly benefit form delaying repayment. For every dollar a borrower spends on student loan interest, they will save at most 22 cents on their taxes.

Opportunity Costs – The real expense of early repayment

When you make a student loan payment, that money is gone forever. If you spend $500 on your student loans, you can’t spend that $500 on anything else. In economics, this concept is called opportunity cost.

Put simply, if we focus on paying off student loans, other financial goals must be delayed or ignored. These deferred goals are some of the biggest hidden costs of paying off student loans early.

Saving for Retirement – As student loan borrowers start planning their financial future, a decision must be made between putting money in a retirement account or paying off student debt. Borrowers with high-interest student loan debt will usually want to pay off the loans before getting serious about retirement, while borrowers with low-interest student loans can come out ahead by getting an early start on retirement.

A generous employer matching program should often be a higher priority than student debt elimination. Similarly, many borrowers choose to refinance their student loans at a lower interest rate to free up cash to save for retirement. This site has previously broken down the options and provided a suggested order of priority for borrowers looking to balance retirement goals with repayment goals.

Buying a House – Purchasing a home and balancing student loan repayment can be very complicated. Qualifying for a mortgage often requires setting aside money for a down payment. To student loan borrowers, it can be very frustrating seeing money in a savings account, earning very little interest while they are being charged a much higher interest rate on their student debt. However, homeownership provides many personal and financial benefits.

Most borrowers will find that with a bit of planning, they can qualify for a mortgage. Usually, this strategy will involve attacking certain student loans before buying a house while leaving others for aggressive repayment after the home has been purchased.

Loan Forgiveness – Another hidden cost of paying off student loans is that you might miss out on student loan forgiveness. Most government programs take ten years or more to qualify, but there are many forgiveness programs that borrowers should investigate.

Some borrowers are worried that paying off their student loans might be a mistake depending upon the results of the 2020 election. We think such regrets are unlikely, but if a new President forgives existing student loan debt, many borrowers will wish they saved for retirement instead of spending extra on their student loans.

The large cost of a small emergency fund

Having an emergency fund is essential.

The idea behind an emergency fund is to have money set aside in case an unexpected expense comes up. These unexpected expenses can include medical bills, a car accident, or an urgent home repair.

Additionally, an emergency fund is necessary if you lose your job. Without any income, putting a roof over your head and food in your belly can be a challenge.

Due to the high risks associated with not having an emergency fund, student loan borrowers should first build up their cash reserves before they pay off their student loans early. This site has previously taken a deeper look at how much should be in an emergency fund and how to balance the fund with student loan repayment.

Eyes on the prize

The point of this article is not to scare borrowers away from early student loan repayment. In fact, it is the opposite. Most borrowers benefit from eliminating student debt. The goal was to shed some light on a couple of myths and help borrowers make an informed financial decision.

Paying down student loans generates a guaranteed return on your investment. Interest savings add up, and monthly payments can get eliminated. The financial and non-financial advantages to debt elimination can be staggering.

Getting rid of student loans can be very satisfying, and the right strategy can make the debt disappear surprisingly quickly.

About the Author

Student loan expert Michael Lux is a licensed attorney and the founder of The Student Loan Sherpa. He has helped borrowers navigate life with student debt since 2013.

Insight from Michael has been featured in US News & World Report, Forbes, The Wall Street Journal, and numerous other online and print publications.

Michael is available for speaking engagements and to respond to press inquiries.

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