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Prepayment

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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.

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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 The Higher Education Opportunity Act of 2008 (PL 110-315) amended the Truth in Lending Act (15 USC 1631) to add section 140(e) to ban fees or penalties for early repayment or prepayment of any private education loan. Even before this change all private student loans provided 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.

INTEREST SAVINGS Loan Term
Prepayment Frequency 10 years 12 years 15 years 20 years 25 years 30 years
Monthly $4,825
(61.5%)
$6,008
(63.2%)
$7,975
(65.7%)
$11,725
(69.8%)
$15,871
(73.3%)
$20,750
(76.7%)
Quarterly $2,772
(35.3%)
$3,502
(36.8%)
$4,784
(39.4%)
$7,418
(44.2%)
$10,534
(48.7%)
$14,517
(53.6%)
Semi-Annually $1,725
(22.0%)
$2,178
(22.9%)
$3,005
(24.8%)
$4,800
(28.6%)
$7,023
(32.4%)
$10,117
(37.4%)
Annually $1,017
(13.0%)
$1,263
(13.3%)
$1,733
(14.3%)
$2,807
(16.7%)
$4,168
(19.3%)
$6,300
(23.3%)

LOAN TERM REDUCTION Loan Term
Prepayment Frequency 10 years 12 years 15 years 20 years 25 years 30 years
Monthly 5.8 years
(57.5%)
7.2 years
(59.7%)
9.3 years
(61.7%)
13.0 years
(65.4%)
17.3 years
(69.0%)
21.6 years
(71.9%)
Quarterly 3.2 years
(31.7%)
4.0 years
(33.3%)
5.3 years
(35.0%)
7.9 years
(39.6%)
10.9 years
(43.7%)
14.3 years
(47.8%)
Semi-Annually 1.8 years
(18.3%)
2.3 years
(19.4%)
3.2 years
(21.1%)
5.0 years
(25.0%)
7.0 years
(28.3%)
9.7 years
(32.2%)
Annually 1.0 years
(10.0%)
1.3 years
(10.4%)
1.8 years
(11.7%)
2.8 years
(14.2%)
4.2 years
(16.7%)
5.9 years
(19.7%)

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.

Even if the lender treats the prepayment as accelerating the next installment, the payment is applied to the outstanding loan amount the same way as if it were treated as an extra payment to principal. The payment is credited immediately to your account and is not held in escrow for delayed application to the loan balance. The main practical difference is whether the lender changes the due date for the next payment. If you make the monthly payments on your own without prompting from the lender, this won't affect you. But if you have the lender direct debit the monthly payments from a bank account, delaying the next due date might mean that you don't end up accelerating repayment of the debt. So it is best to include a note requesting that the extra payment be applied directly to principal and not treated as early payment of a future installment.

Due to the way the income-contingent and income-based repayment plans treat interest, it is not advisable to prepay a loan in the income-contingent and income-based repayment plans.

If you have several loans with the same lender, you may wish to specify that the extra payment be applied to a specific loan. Generally, if the extra payment is applied to the highest cost loan (e.g., the one with the highest interest rate) you will save the most money. If you do not specify how the extra payment should be applied to your loans, the lender may apply it to the lowest cost loan or uniformly to all your loans. For example, if you have subsidized Stafford loans and unsubsidized Stafford loans with the same lender, you should ask to have the prepayment applied to the unsubsidized Stafford loan. Likewise, if you have both federal and private student loans with the same lender, you should specify that the prepayment is applied to the private student loan. Otherwise the lender will apply the extra payment in a way that is in the lender's best interest, not yours.

 

 
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