Borrowers can save money on their student loans by accelerating repayment of the loans by making extra payments. There are no prepayment penalties on federal and private student loans, so nothing stops the borrower from accelerating repayment of the debt. These extra payments will reduce the principal balance on the loans.
One of the best strategies for saving money is to target the extra payments to the loan with the highest interest rate. (This can include credit card debt and other forms of consumer debt, not just student loan debt.) This will reduce the total interest paid over the life of the loans. It will also lead to quicker repayment of all the loans.
How to Make an Extra Payment
Follow these steps to make an extra payment on a loan:
- Make the required monthly payments on time, by the due date. Be sure to send the payment at least a week before the due date to allow enough time for the payment to be received and processed by the due date.
- A few days after the due date, mail a check for the extra payment to the loan’s servicer.
- Write the loan ID number on the check.
- Include a cover letter with the check specifying that the prepayment is to be applied as a prepayment to the principal balance of the loan with the highest interest rate and not as an early payment of the next installment.
- A week later, use the lender’s online interface to verify that the prepayment was correctly applied to the balance of the correct loan. If it was not correctly applied, contact the lender to insist on the extra payment being correctly applied, as instructed in the cover letter.
If a servicer receives a check without instructions, the servicer might treat it as an early payment of the next installment due. The federal regulations at 34 CFR 682.209(b) and 34 CFR 685.211(a) require lenders to “apply the prepayment to future installments by advancing the next payment due date, unless the borrower requests otherwise.” This can cause the lender to skip the next installment if the borrower is enrolled in auto-debit. The lender might also apply it to the loan with the closest due date or the lowest interest rate, spread it out among all the loans or apply it to a randomly selected loan.
Note that most lenders require payments to be applied first to any late fees and collection charges, second to any accrued but unpaid interest and finally to the principal balance. (Under the income-contingent repayment (ICR), income-based repayment (IBR) and pay-as-you-earn repayment (PAYE), payments are first applied to accrued interest, second to collection costs, third to late fees and fourth to the principal balance.) If the borrower is current on the debt, the extra payment may be first applied to the small amount of interest that accrued since the last payment. The rest is then applied to the principal balance of the loan. Don’t worry about the prepayment being applied to some interest, because this just means that more of the next regular installment will be applied to principal instead of interest. Lenders do not hold the payment until the due date; they immediately apply the payment as a credit to the loan balance. Making the extra payment soon after the normal payment due date will minimize the interest.
Impact of Prepayment
Making extra payments on a loan can cut years off the repayment term. For example, a $20,000 loan at 6.8% interest will require monthly payments of $152.67 on a 20-year repayment term. If the borrower makes an extra payment of $50 a month, it will cut 7.9 years off the 20-year repayment term and save $7,259 in interest over the life of the loan. If the borrower increases the monthly payment to $230.16, the monthly payment under a 10-year repayment term, not surprisingly the loan will be paid off in 10 years instead of 20 years, saving $9,020 in interest over the life of the loan.
Smart Strategies for Targeting Extra Payments
The smartest strategy for targeting prepayments is to make the extra payments on the loan with the highest interest rate. This will save more money and pay off the loans quicker than spreading the extra payment among all the loans (e.g., by decreasing the loan term) or by targeting the loan with the lowest loan balance for quicker repayment.
Consider a borrower with two loans with a 10-year repayment term, a $15,000 loan with a 10% interest rate and a $5,000 loan with a 5% interest rate. This table shows the results of different strategies for applying an extra $100 a month toward the pair of loans. While targeting the smallest loan first for quicker repayment – the so-called snowball strategy – causes that loan to be paid off in just 3 years, both loans aren’t paid in full until 7 years and 1 month. Not only does targeting the loan with the highest interest rate first cause all the loans to be paid in full in just 6 years and 11 months, quicker than any other strategy, but it also saves an extra $1,386 more than the snowball strategy.
While the snowball strategy may sometimes lead to a shorter time to paying off the first loan, perhaps giving a slight psychological boost, the borrower still has to stick with a prepayment strategy for years before seeing measurable progress in paying down the debt. Targeting the highest interest rate loan for quicker repayment is still the best strategy because it saves the borrower the most money and leads to the quickest payoff of the entire debt.
How to Get Extra Money to Prepay Debt
There are several approaches to getting extra money to accelerate repayment of student loan debt.
First, there are potential sources of savings that do not target a specific loan for quicker repayment. These include the student loan interest deduction, auto-debit discounts and Upromise. Not only can Upromise be used to earn rebates that are contributed to a 529 college savings plan before enrollment, but the rebates can also be used to pay down debt after the student graduates.
Next, one can selectively change the repayment terms on some of the loans. For example, if the highest-rate loan is a private student loan and the lowest-rate loans are federal student loans, the student could choose a longer repayment term on the federal student loans and a shorter repayment term on the private student loans. This will yield more savings over the life of the loan even if it does not change the total monthly payment.
The borrower might be able to get extra money for making prepayments by earning an education award from volunteer work (e.g., AmeriCorps), by getting loan repayment assistance from the borrower’s employer or by benefiting from other loan forgiveness programs.
Otherwise, the borrower will need to earn more and spend less to get extra money to pay down the debt. Some sacrifice is worthwhile to get rid of the student loan debt quicker. Options for earning more money include:
- Get a part-time job in the evenings and weekends. Not only does this yield extra money for accelerating repayment of the debt, but it also leaves less time to spend money.
- Earn extra money by asking for a raise after putting in extra hours at work.
- Start a business by selling craft items or other widgets on eBay. Sell extra belongings on eBay. Anything that hasn’t been used in over a year is not needed and can be sold.
Options for spending less include:
- Split the rent with a roommate or cut housing costs by moving back in with parents or other relatives.
- Sell the expensive car and replace it with a less expensive car or use public transportation.
- Spend less on eating out, paid entertainment and other discretionary spending.
- Substitute free activities and services for paid items, such as a walk around the block for a gym membership.
- Cell phones and cable TV are luxuries, not necessities. If a cell phone is required for work, get the employer to pay for it. Otherwise, there are cell phone services that cost less than $200 a year. If a cell phone is required only for emergencies, cell phone service is not necessary. Cell phones can still dial 911 even if they aren’t connected to a cell phone carrier.
If getting out from the student loan albatross isn’t sufficient motivation, motivate with a series of rewards. A small reward after every twelve prepayments and a larger reward after the debt is paid off in full can help borrowers deal with delayed gratification by associating a tangible benefit with progress toward retiring the student loan debt. It can be as simple as a celebratory dinner at a favorite restaurant or a night out at a ball game or the movie theater.
It can also help to make the prepayment strategy automatic, by setting up an automatic monthly transfer to make the extra payments. In some cases, the lender will reduce the loan’s interest rate for borrowers who utilize this automatic transfer strategy.