Is there a penalty to paying off my federal student loan early?

Michael Lux Blog, Money Saving Tips, Student Loans 0 Comments

Federal student loans can be a huge headache, but fortunately, penalties for paying off the loans early are not an issue.  There are no prepayment costs and the interest rate does not go up if you pay early.

In fact, with the interest rate compounding on a daily basis, the true cost comes from paying as little as possible.  The sooner you pay off your debt the less you spend in the long run.

Taking advantage of zero penalties…

There are a couple of ways to take advantage of the fact that there are not any prepayment penalties.

First, and perhaps most importantly, you can aggressively pay of your debt as fast as possible.  A bonus at work or extra cash left over at the end of the month can get you debt free that much faster.

Additionally, borrowers with good credit and income can take advantage of student loan refinancing companies.  These lenders will pay off your federal loans entirely and leave you with a new loan at what is hopefully a much lower interest rate.  When you borrow student loans to attend school, you most likely didn’t have a job, a degree, or much of a credit score.  By attending school, you hopefully received a degree which lead to a better job and credit score.  The refinancing lenders take advantage of the fact that you are a much less risky borrower and offer lower interest rates than the federal government.  They make money and borrowers can refinance without penalty and save a bundle due to the lower interest rates.  Some lenders, such as SoFi and CommonBond even offer $150 to new customers just for signing up.  This financial move would be far less effective if there were prepayment penalties on federal loans.

Mistakes to avoid…

Just because you can pay off your loan without a prepayment penalty does not mean it is a good idea.

For starters, there may be other debt that makes more sense to address first.  For example, if you have a high interest private student loan, you will probably want to pay that off before addressing your federal loans.  This approach calls for paying just the minimum on your federal loans (so that your balance does not grow) and then attacking the private loan. Once the private loan is eliminated, you can shift your focus to the federal debt.

Another mistake that people sometimes make when aggressively paying off their loans is that they pay money towards the loan whenever they have it, ignoring the monthly billing cycle.  Priority one should be ensuring that you are always able to meet minimum payment deadlines.  After that, you want to be paying as much as possible as soon as possible.  If you pay three times the minimum in one month, but nothing the next month, you will get beat up by late fees.

Finally, borrowers should use extreme care when refinancing their federal loans.  Taking advantage of the zero penalty prepayment is great, but if the new loan is a bad idea, there is no way to undo the decision.  Federal borrowers need to give special consideration to the perks that come with federal loans.  These would include public service student loan forgiveness and repayment plans based upon your income.  If you will ever need to take advantage of the programs that come with federal student loans, the private refinance can be a mistake.

Bottom Line

With zero prepayment penalties on federal loans, there are opportunities for borrowers to save money.  If you avoid some common mistakes, the savings could be huge.