There are no formal penalties for prepaying federal student loans or private student loans. Lenders are banned from charging additional fees when a borrower makes extra payments on their student loans or pays off the student loan balance early. However, a few additional steps may be necessary to ensure that student loan prepayments are applied to the principal balance of the loan with the highest interest rate.
Prepayment Penalties Are Not Permitted on Student Loans
Federal law prohibits lenders from charging prepayment penalties on all education loans, including both federal student loans and private student loans.
The assessment of prepayment penalties on federal student loans has been banned since the original passage of the Higher Education Act in 1965, which states that borrowers may “accelerate without penalty repayment of the whole or any part of the loan.”
The Higher Education Opportunity Act (HEOA) amended the Truth in Lending Act (TILA) in 2008 to ban prepayment penalties for private student loans as well.
Other Types of Loans and Prepayment Penalties
While student loans are exempt from prepayment penalties, other types of loans do allow the lender to assess penalties. Such prepayment penalties must be clearly stipulated in the loan promissory note. Prepayment penalties are usually expressed as a percentage of the loan balance or as a flat fee.
Some of the most common types of loans that assess prepayment penalties include home mortgages, auto loans and personal loans.
- Home mortgages: Federal Housing Authority (FHA) loans are exempt from prepayment penalties, but penalties may be assessed for conventional loans. This has become less common following the housing crisis of 2008 and the passage of restrictive legislation in 2014, but it still occurs.
- Car loans: Currently, 36 states and Washington, D.C., allow prepayment penalties on car loans with terms shorter than five years. Penalties are, however, prohibited nationwide for loans with terms of longer than five years.
- Personal loans: The assessment of prepayment fees for personal loans varies by lender. Many lenders provide personal loans with no prepayment fees.
Advantages of Prepaying Student Loans
Making prepayments on student loans reduces the total interest paid. It also pays off the debt quicker. This may save the borrower thousands of dollars in interest that might have otherwise accrued.
If a borrower is able to pay off the principal balance of a subsidized loan before the loan enters repayment, they could avoid paying any interest on the loan. In effect, they would have received an interest-free loan during the in-school and grace periods.
It is better to have the prepayments applied to the loan with the highest interest rate. This will save the borrower the most money over the life of the loan by paying off the most expensive loan first. It reduces the weighted average interest rate on the borrower’s loans.
Generally, if a borrower has both federal and private student loans, the prepayment should go toward the private loans, which typically have a higher interest rate than the federal loans.
Accelerating repayment of the loans with the highest interest rates first is known as the avalanche method. The snowball method, which will likely take longer and be more expensive in the long run, entails paying off the loan with the smallest loan balance first.
While the benefits of prepaying are clear — paying less interest and reducing the repayment term — there are some caveats borrowers should consider before putting extra money toward their student loans.
If the borrower carries a balance on their credit cards, they should pay off their credit card debt first. Credit card debt is usually more expensive than student loans. Generally, borrowers should pay off debts that charge higher interest rates than their student loans before prepaying their student loans.
Borrowers should also ensure that they have around six months of savings for emergencies before embarking on a prepayment plan.
It may also be advisable to consider putting extra money toward retirement, if the earnings on the retirement plan exceed the highest interest rate on the student loans. Generally, this means maximizing the employer match on contributions to the borrower’s retirement plan, as that’s free money. Otherwise, paying down high interest student loan debt may save more money.
How to Prepay Your Student Loans
The regulations at 34 CFR 682.209(b) and 34 CFR 685.211(a) provide that a prepayment is applied as an early payment of the next installment, as opposed to as an extra payment, unless the borrower requests otherwise.
This is why it is important for the borrower to provide instructions to the lender to ensure that the prepayment is applied as the borrower wishes. If the borrower is signed up for auto-debit, the lender may skip the next payment if the borrower does not specify otherwise.
Likewise, some lenders will recalculate the monthly loan payment based on the new loan balance and the remaining term on the loan. This will yield a lower monthly payment, preventing the loan from being paid off quicker.
The Consumer Financial Protection Bureau provides a form letter that borrowers can use to provide instructions to the loan servicer.
The instructions should specify that the prepayment is an extra payment toward the principal balance of the loan and should not be treated as an early payment of the next installment. In particular, the lender should not advance the due date of the loan.
The instructions should specify the loan ID of the loan or loans to which the prepayment should be applied. Generally, the borrower will save the most money if the extra payment is applied to the loan with the highest interest rate.
Otherwise, the lender might apply the extra payment to the loan with the earliest due date, the latest due date, the lowest loan balance, the highest loan balance, the lowest monthly payment, the highest monthly payment, the lowest interest rate, the highest interest rate, evenly or proportionately among all of the loans, or just randomly.
The instructions should specify that the lender should not re-amortize the loan due to the lower loan balance, but instead continue to bill the previous monthly payment amount.