Student loan payment allocation can make a massive difference in debt elimination.
How important is payment allocation? If two borrowers had identical loans, identical payment amounts, and made payments at the same time, the borrower with improperly allocated payments could easily spend thousands more than the borrower with a smart allocation strategy.
Today we will look at payment allocation from two perspectives:
- Making sure payments count towards principal and not interest, and
- Identifying opportunities to eliminate problematic debt first.
A clever allocation strategy doesn’t necessarily mean spending more money each month. Instead, it just ensures that your debt gets eliminated as quickly as possible.
The Standard Rules for Payment Processing
When you make the minimum monthly payment on your student loan, there are no allocation decisions to make.
Whether your loans are federal or private, minimum payments get allocated the same way.
First, a portion of the payment is used to pay off any outstanding late fees on your loan account. Second, the payment is used to pay off interest that accrued the previous month. Finally, the remaining funds lower your principal balance.
The key takeaway is that borrowers can’t call their lender and ask that 100% of next month’s payment be applied to the principal balance.
Paying Extra is Smart
For borrowers early in the repayment process, a monthly payment could be almost entirely interest.
This is the lender’s preference. Lenders make money on interest and fees. When the principal balance is lowered, the borrower is just repaying the money they borrowed. If a borrower pays large amounts of interest and hardly touches the principal balance, the loan could linger for decades, with the borrower paying far more than originally borrowed.
I’ve seen cases where a borrower took out $60,000 of student loans, paid a total of $80,000, and had a balance of $50,000. Factoring in loan balance growth during school and other deferments, the numbers can quickly get crazy.
Paying the tiniest bit extra can make a difference. For borrowers early in repayment, paying $10 extra can be like making a double payment.
Sherpa Tip: Paying extra isn’t always the best idea. Sometimes, building up an emergency fund or saving for retirement is the better choice.
Similarly, if you are on your way to federal student loan forgiveness, paying extra could mean that less debt gets forgiven.
Allocating Payments Toward Principal Instead of Interest
Extra payments are almost always made with the goal of paying off the loan faster.
In many cases, lenders and servicers will take the extra funds and immediately lower the principal balance on the loan. This is typically the desired approach.
However, some lenders put the loan in a “paid ahead” status. Instead of immediately crediting the borrower, the lender uses the extra payment to count towards future payments. In other cases, the lender will use the additional amount to lower the minimum payment due for future payments.
It is relatively simple to avoid these issues. If you pay $100 extra, your principal balance should drop by an extra $100. If it doesn’t, call your lender and ask for an adjustment.
Once you get things squared away with your lender or servicer, no additional effort is required. That said, it is always a good idea to occasionally check your statements and balance history to ensure things are handled correctly.
Further Reading: More tips on getting payments to count towards principal instead of interest.
Payment Allocation Choices
Most borrowers have more than one student loan. For some borrowers, it means multiple loans with the same lender. For others, it means multiple lenders. Many of us have multiple loans with multiple lenders to manage.
If you are going to pay extra, the critical detail is that you pick one loan to attack.
Many borrowers opt for the loan with the highest interest rate. Others select the loan with the smallest balance. Some choose to pay off loans with a cosigner first.
Of the many repayment strategies available, most borrowers will benefit from attacking their high-interest private loans first.
There isn’t a right or wrong order to paying off your student loans.
Sherpa Tip: Even if you pay extra each month, it doesn’t hurt to ask for lower monthly payments on your student loans.
Lowering the minimum monthly payment on a low-interest loan frees up more cash each month to attack the high-interest loan.
Target One Loan at a Time
Allocating extra payments toward a single loan is the ideal path to eliminating debt.
To be clear, you must make minimum payments on all your loans. However, extra payments all get directed toward a single loan.
I often see borrowers who pay a little bit extra on all of their loans. It isn’t a bad strategy. This approach is certainly better than just paying the minimum on all of the loans. However, it isn’t the best strategy.
By targeting a single loan, it gets eliminated faster. That means it falls off your credit report faster and opens up your budget faster. At that point, you can move on to the second loan.
I call paying a little extra on all loans the responsible borrower mistake. It can easily be a $1,000 error.
Reallocating Previous Payments
If your lender processes your extra payment incorrectly, you can usually fix things with a quick phone call.
Things are far more complicated if you want to change years worth of payments. However, it is still possible.
For example, some federal borrowers who made payments during the Covid-19 payment pause have received emails offering the opportunity to reallocate their payments. This is an excellent opportunity to make sure the payments get applied using your ideal strategy.
Additionally, borrowers who made payments during the pause can also request a refund on payments made. Borrowers can take that check and make a new payment toward a single loan. Going this extra step essentially reallocates things if your servicer isn’t willing to help.
There Isn’t a “Best” Allocation Strategy
A borrower concerned about interest spending will first want to pay off the loan with the highest interest rate.
Someone who wants to buy a house may find that eliminating the loan with the smallest balance is the best approach.
Other borrowers may want to use one of the many different strategies available for loan repayment order.
Because there isn’t a definitive best repayment order, there isn’t an ideal allocation strategy. As a result, borrowers shouldn’t assume that their loan servicers will handle things according to their wishes.
Once you settle on the strategy that meets your needs, ensure your lenders and servicers follow your instructions.