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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.

While paying off student loans early is a commendable goal, aggressive repayment comes with its costs. Focusing solely on student debt may cause borrowers to overlook other financial opportunities and make mistakes.

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

Should I Be Concerned 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 impose any fees for early repayment of student loans. Furthermore, private student loan lenders have been prohibited from charging prepayment fees since 2008. According to 15 U.S.C. § 1650(e), lenders are not allowed to 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.

Will Delaying 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.

However, even if there is a risk of a credit score drop, the impact is minimal. 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. 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 first 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 paying off their student loans because of the tax break they receive.

This is an ill-advised idea. The deduction applies only to a portion of the student loan interest paid, and it provides a meager tax benefit.

Many borrowers may not even qualify for this tax break, and those who do will hardly benefit from delaying repayment. For every dollar spent on student loan interest, the maximum tax savings will be 22 cents.

Opportunity Costs – The True Expense of Early Repayment

When you make a student loan payment, that money is permanently gone. If you spend $500 on your student loans, you cannot use that $500 for anything else. In economics, this concept is known as opportunity cost.

To put it simply, if we focus solely on paying off student loans, other financial goals must be postponed or neglected. These deferred goals represent some of the most significant hidden costs of early student loan repayment.

Saving for Retirement – As student loan borrowers plan their financial future, they must decide between contributing to a retirement account or paying off their student debt. Borrowers with high-interest student loan debt will generally want to prioritize loan repayment before focusing on retirement, while borrowers with low-interest student loans can get a head start on retirement by making early contributions.

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 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. For student loan borrowers, it can be frustrating to see money sitting in a savings account, earning minimal interest, while being charged a much higher interest rate on their student debt. However, homeownership offers numerous personal and financial benefits.

With careful planning, most borrowers can qualify for a mortgage. Typically, 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 paying off student loans early is the potential loss of student loan forgiveness. Most government programs require ten years or more to qualify, but there are many forgiveness programs that borrowers should investigate.

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.

Moreover, an emergency fund is essential in the event of job loss. Without any income, ensuring a roof over your head and food on the table can become challenging.

Due to 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. Most borrowers benefit from eliminating their student debt. The goal is to dispel a few myths and help borrowers make 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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