First you should know that all education loans allow for prepayments to be made without a penalty being assessed. This means that you can make extra payments to reduce the principal or even pay off the entire balance at once, without having to pay a fee. Also be aware that when a lender receives any payment on a loan, the payment is applied first to late charges and collection costs, if any, then to outstanding interest and then to outstanding principal. The lender can also apply an extra payment towards the next payment due. For these reasons, I recommend that when making an extra payment that you include a notation on the memo section of your check specifying that you want the prepayment applied to the principal. If you have several loans with the same lender you should also specify which loan the extra payment is to be applied to. Keep a copy of the check in the event the extra payment is misapplied.
Second, when advising someone on a debt payment plan several factors must be considered such as determining their annual income and expenses, whether the individual has an established emergency fund, reviewing other outstanding debt such as credit cards or auto loans that may have higher interest rates, funding a retirement plan, if possible, and taking into consideration tax issues such as the student loan interest deduction. Keeping in mind that even with the best current savings rates averaging 0.80 (that’s less than 1% per year) the best use of your money is to pay down higher interest debt such as this student loan and apply any available extra funds to paying down the principal. In almost all debt situations you want to apply extra payments to the principal not the interest. Prepayment of the principal saves money because subsequent monthly payments will further reduce the principal regardless if an extra payment is made in the future. Prepayment of the principal also reduces the total interest that you will pay over time.
Paying off student loans is one of the best financial moves a person can make. By paying off student loans a person clears the way for other financial objectives like buying a home and saving for retirement. In addition, unlike most other debt, student loans are very difficult to discharge in bankruptcy so paying them off should be a top priority.
Anthony J. Vignier, JD, CFP is an attorney and Certified Financial Planner in Kearny, New Jersey. He helps his clients with legal matters, asset and income protection strategies as well as investment guidance. Please call Anthony at (800) 707-5252 or send him a message through our contact form.