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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.

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Eliminating student debt should be a priority for all borrowers. Student loans not only cause significant stress but also accrue interest rapidly.

However, while paying off student loans early is a commendable goal, aggressive repayment can have drawbacks. Focusing solely on student debt may cause borrowers to overlook financial opportunities and make mistakes.

Today, we will explore how to avoid repayment mistakes and prepayment penalties. We’ll also discuss strategies for integrating early student loan repayment into your broader financial goals.

Should I Be Concerned About Prepayment Penalties with Student Debt?

Student loan borrowers who are ready for aggressive debt elimination needn’t worry about prepayment penalties.

The federal government does not impose any fees for early repayment of student loans. Furthermore, Congress has prohibited private student loan lenders from charging prepayment fees since 2008. According to 15 U.S.C. § 1650(e), private educational lenders may not impose “a fee or penalty on a borrower for early repayment or prepayment of any private education loan.”

In short, lenders cannot penalize borrowers who wish to tackle their student loans ahead of schedule.

Will Early Student Loan Repayment Affect My Credit Score?

Some borrowers worry that early student loan repayment may negatively impact their credit score.

There is some truth to this concern, as some borrowers have reported a drop in their credit score after paying off a student loan. The most likely explanation is that the borrower’s oldest line of credit, the student loan, no longer appears on their credit report. When the oldest line of credit disappears that average length of credit is shortened, and this can reduce a credit score.

However, even if there is a risk of a credit score drop, the impact is typically minor and temporary. If the score does decrease, it will likely be a small change, and the score should recover fairly quickly. Consider this: if a credit score is a measure of creditworthiness, shouldn’t paying off a loan improve the score?

Ultimately, spending extra money to artificially boost a credit score rarely makes sense. In most cases, a few points in either direction has no impact on the consumer, so spending extra money each month for a few extra points would be a huge waste of money.

In very rare instances, delaying a final payment can make sense. For example, 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. Depending on your financial situation, they may advise you that paying off the student loan first might be helpful. Other times, they 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 paying off their student loans because of the tax break they receive.

This strategy is generally not advisable, however. The deduction applies only to a portion of the student loan interest paid and provides a meager tax benefit.

Some borrowers may not even qualify for this tax break. Furthermore, those who do qualify will hardly benefit from delaying repayment. For every dollar spent on student loan interest, the maximum tax savings will be 22 cents. This small saving usually doesn’t justify the additional interest costs accrued by prolonging the loan repayment.

Opportunity Costs – The True Expense of Early Repayment

When planning their financial futures, student loan borrowers often face choices between paying off the student debt or working towards other goals.

When you make a student loan payment, that money is gone for good. For example, if you spend $500 on your student loans, you cannot use that $500 for anything else. Economists call this concept as opportunity cost.

To put it simply, if we focus solely on paying off student loans, we will postpone or neglect other financial goals. These deferred goals represent some of the most significant hidden costs of early student loan repayment. The following are some examples of the decisions student loan borrowers must face:

Saving for Retirement – For those with high-interest student loans, it usually makes sense to prioritize paying off the debt before focusing on retirement. However, borrowers with lower interest rates on their loans might benefit more from starting to save for retirement early.

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

Buying a House – The process of purchasing a home while managing student loan repayment can be quite complex. Qualifying for a mortgage often requires setting aside funds for a down payment. However, it can be frustrating to see money sitting in a savings account earning minimal interest while being charged a much higher interest rate on the student loans. Despite such frustrations, homeownership offers numerous personal and financial benefits that can make the irritations worth it.

With careful planning, many borrowers can qualify for a mortgage. Often, this strategy involves prioritizing the repayment of specific student loans before buying a house, while addressing others through aggressive repayment after the home purchase.

Loan Forgiveness – Another hidden cost of early student loan repayment that borrowers often overlook is the loss of potential student loan forgiveness. Many government programs require ten years or more to qualify. However, there are numerous forgiveness programs that borrowers should investigate before deciding to pay off their loans early.

The Significant Cost of a Small Emergency Fund

Having an emergency fund is crucial.

An emergency fund serves as a safety net, providing funds for unexpected expenses such as medical bills, car accidents, or urgent home repairs. Additionally, an emergency fund is essential in the event of job loss. Without any income, making sure that a roof stays over your head and food still arrives on the table can become challenging.

Given the high risks associated with not having an emergency fund, student loan borrowers should prioritize building up their cash reserves before focusing on early loan repayment. 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.

Keeping Your Eyes on the Prize

The purpose of this article is not to discourage borrowers from repaying their student loans early. In fact, it is quite the opposite. Many borrowers benefit from eliminating their student debt early. The goal here is to dispel a few myths and help borrowers make well-informed financial decisions.

Paying off student loans guarantees a return on your investment. The savings on interest accumulate, and monthly payments can be eliminated. The financial and non-financial advantages of debt elimination can be significant.

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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