Clock with Student Loan Repayment

Understanding Student Loan Prepayment and Extra Payments

Michael Lux Blog, Strategy, Student Loans 0 Comments

Prepayment of student loans is a common strategy to save money on interest over the life of the loan.  Borrowers make “prepayments” on their student loans when they pay more than the amount due, often long before the debt is due.  Some borrowers choose to pay a little bit extra when they can afford it, while other borrowers make large lump sum payments in order to pay off a loan entirely.  Both approaches will pay off a loan faster, but also come with risks.

How is the early/extra payment processed?

Lenders procedures for handling prepayments can vary from company to company.  Generally speaking, loan prepayments are handled in the following order:

  1. Penalties and Fees – If a borrower has been charged any fees or penalties, such as late fees or charges for a bounced check, prepayment funds will first be used to eliminate these balances.
  2. Accrued Interest – Prepayments are then use to pay down interest that the student loan has generated.  If a borrower continues to make regular payments, none of the prepayment should be applied towards interest.
  3. Principal Balance – Once fees and interest have been paid, the remaining funds reduce the principal balance.  Knocking down the principal balance is the goal of prepayments.

When making large or extra payments, borrowers should pay close attention if they have multiple loans with the same lender.  Typically, borrowers will want the entire extra payment to be applied to the loan with the highest interest rate.  Some lenders will apply the prepayment equally across all loans if they are not given special instructions.  When one lender holds multiple loans it is important to give specific instructions for extra payments AND to follow up to make sure that your instructions were followed.

Some lenders also use prepayments to delay the due date for future payments.  For borrowers that pay a large lump sum, it could mean that the next payment isn’t due for a number of years.  Lenders do this to allow interest to build back up on the account.  Borrowers who make large payments are usually better off if they continue to make their regular payments, whether they get a bill or not.  This practice varies from lender to lender.

Prepayment Penalties

One thing to keep in mind is that some loans do come with prepayment penalties.  In the student loan world these are very uncommon, but borrowers should be aware.  If you are considering paying extra towards your student loans, it is a good idea to your lender to verify that there are no prepayment penalties associated with your loans.

Advantages of paying extra…

There are three major benefits to paying extra on your student loans.

  1. Less spending on interest – When the principal balance is lowered, it means that the loan generates less interest each day.  That means paying an extra $100 today will save money every month for the life of the loan.  Paying a loan off entirely ends the lender profit stream and frees up money each month for the borrower.
  2. Improved finances – Paying off a loan can dramatically improve your finances.  Applications for mortgages and other loans are more likely to be granted.  In the event of a job loss, emergency funds will last longer when there is less debt.
  3. Peace of Mind – Dealing with student loans and finding the cash to make monthly payments can be a great source of stress.  For many, eliminating debt is eliminating things to worry about.

Deciding on the student loan to prepay

Paying a little bit extra on all of your student loans will save money in the long run.  However, targeting a specific loan to attack is often the optimal strategy. Planning and strategy are very important.

If you have multiple student loans, there are a couple approaches that can use with your extra payment:

Option 1: Pay Down the Highest Interest Loan – This one is usually the recommended approach.  The plan is very simple.  Use whatever extra money you have to pay down the balance of your student loan with the highest interest rate.  Mathematically, this is almost always the most efficient use of your money.

Option 2: Pay Off a Small Loan in Full – If you have enough money to pay off a loan in full, this can be a very tempting option.  Even if you can’t pay the entire loan off now, attacking a small loan first can get debt wiped off the ledger as fast as possible.  Paying off a loan completely will eliminate a monthly payment for you going forward.  This win can help your monthly balance sheet, provide some financial flexibility, and help you find the motivation to attack the rest of your student debt.

What not to do: Split the payment evenly across all of your loans – Doing this is better than just paying the minimum, but it is still a lousy strategy.  It lacks the interest saving power of option 1 and it lacks the flexibility and motivation of option two.

Risk of Early Payments

The big danger with prepayment is that once the money is paid, you never get it back.  Just because you are $500 ahead on your payments does not mean the lender will send you a check for $500 if you find yourself strapped for cash.  For this reason it is important to have an emergency fund in place to deal with any potential financial hardship.

Having an emergency fund in place is critical to smart financial planning.  The general recommendation is to have three to six months worth of expenses saved away in case of an emergency.  For people with lots of student debt who do not have children dependent upon them, this number can get shaved down a bit.  An individual’s ability to find new work or additional income quickly will also impact how much money should be set aside in an emergency fund.

While there is some room for debate about the proper amount to set aside, there is no debating the necessity of having an emergency fund.  With an emergency fund in place, you can more easily deal with a job loss, car trouble, or unexpected medical expenses.  Without an emergency fund, one problem can quickly become many.

The other concern with prepayment is the opportunity cost.  Money used for a prepayment is no longer available for a home down payment or to start a business.  For this reason, some borrowers elect to refinance their loans with another lender at a lower interest rate.  Going this route allows for saving money on interest while still having the cash on hand to pursue other opportunities.

Bottom Line

Paying extra towards student loans is a great way to spend less on interest and secure a stronger financial future.  Some lenders do require a little babysitting to make sure they process payments correctly, but the extra effort is well worth the savings.