All education loans, including federal and private student loans, allow for penalty-free prepayment. This means you can make extra payments to reduce the balance of the loan, or even pay off the entire balance early, without having to pay an extra fee.

When a lender receives payments on a loan, the payment is applied first to late charges and collection costs, then to outstanding interest and then to outstanding principal. Any amount beyond the amount due (e.g., the late charges and collection costs and the monthly installment as specified in the repayment schedule) is considered a prepayent.

Penalty-Free Prepayment

The right to a penalty-free prepayment of all or part of a federal education loan is established by the Higher Education Act of 1965.¹ There is no statutory or regulatory requirement for private student loans to have penalty-free prepayments. However, all current private student loans provide for penalty-free prepayments for competitive reasons.

Why Prepay?

Prepayment can save you money by paying off your loan earlier and by reducing the total interest paid over the lifetime of the loan. Since the loan balance is reduced, more of your subsequent monthly payments will go toward further reducing the loan balance and less toward interest.

When you have more than one loan, you should apply prepayments toward the more expensive loans first (the loans with the highest after-tax interest rates). This strategy will save you the most money. (Generally, this strategy will involve prepaying first credit cards, then private student loans, then the PLUS loan, then the Stafford loan and last the Perkins loan, since credit cards are the most expensive and Perkins loans are the least expensive.)

The following charts show the interest savings and the reduction in the loan term from making an extra monthly payment periodically for various loan terms. This chart assumes a 6.8% interest rate and $20,000 original loan balance. The reduction in the loan term and the percentage interest savings are the same regardless of the loan balance. The dollar amount of the loan savings, however, varies in proportion to the loan balance.

FinAid has a prepayment calculator which you can use to calculate the impact of different prepayment strategies on your loans. It shows the reduction in the loan term and the total interest saved.

In effect, prepayment reduces the loan term by increasing the monthly payment to the amount associated with the new loan term. For example, a $20,000 loan at 6.8% and a 15 year term has a monthly payment of $177.54. If we prepay $52.62 per month, it brings the monthly payment to $230.16, the monthly payment for a 10 year term, and reduces the loan term by 5 years, yielding the equivalent of a 10 year loan. So another way to achieve (automated) prepayment is to ask the lender for a shorter loan term. Federal regulations allow borrowers to change the loan term at least once a year, so if you find it difficult to make the monthly payments on the shorter loan term, you can always increase the loan term later.

How to Request Prepayment

Federal regulations allow the lender to apply a prepayment to "future installments by advancing the next payment due date" unless otherwise specified by the borrower.² For this reason it is important to include a note with any prepayment indicating that you want the prepayment applied to reduce the principal balance of the loan. Otherwise, the lender will treat it as though you had paid your next installment(s) early, and may delay the next payment due date(s) as appropriate.

This is especially true during periods of deferment (including in-school and grace periods) and forbearance when interest is accruing but not yet capitalized. Likewise for loans in the income contingent repayment program, where the interest is not capitalized after it exceeds ten percent of the original principal amount.³ It is always better to have prepayments used to reduce the loan balance, since this will cost you less over the lifetime of the loan.

It is generally not a good idea to Due to the way the income contingent repayment plan treats interest, it is not advisable to prepay a loan in the income contingent repayment plan.