How to Pay Off Student Loans Faster

By Mark Kantrowitz

You can pay off your student loans quicker by making extra payments. This can also save money by paying less interest over the life of the loans.

There are no prepayment penalties on federal and private student loans, so nothing stops you from paying more than the required minimum monthly payments.

Target the extra payments at the loan with the highest interest rate, to save the most money. When this loan is paid off, accelerate repayment of the loan with the next highest interest rate. This will quickly reduce the average interest rate on your loans, so that more of each payment will be applied to paying down the principal balance of the loans. This avalanche effect will cause all of your loans to be paid off sooner.

Always make the extra payments on the loans with the highest interest rates, not the lowest loan balances. Although some people argue that trying to pay off the smallest loans first will yield "quick wins" to help motivate you to continue making extra payments, it will still take some time to pay off even the smallest loan. Making extra payments on the highest-rate loans first yields more motivation because your loan balance will decrease faster.

Prepayment Pitfalls

Two types of problems can occur when you prepay student loans.

Payment Application Order. Federal rules dictate the payment application order for federal student loans. Payments are applied to the interest that has accrued since the last payment, then the remainder is applied to the principal balance of the loan, per the regulations at 34 CFR 682.209(b) and 34 CFR 685.211(a). Most private student loans follow a similar set of rules.

If you make an extra payment a few days before your regular payment, the extra payment will be applied to interest first. This can cause confusion, because then the principal balance does not decrease as much as you expect. However, since there will be very little interest left before the regular loan payments, most of those payments will be applied to reducing the principal balance.

Even though it's the same difference, you should send in the extra payments a day or two after your regular student loan payments. That way, the extra payments will work the way you expect. Most of the extra payment will be applied to paying down the principal balance, since very little interest will have accrued since the regular loan payments.

Advancing the Next Installment. If the borrower does not request otherwise, prepayments will be treated as an early payment of the next installment and not as an extra payment, per the regulations at 34 CFR 682.209(b) and 34 CFR 685.211(a).

Either way, the payment will be applied to your loan balance upon receipt. But, if the lender treats the prepayment as advancing the next payment due date, the lender may skip the next payment. For example, if the borrower is signed up to have monthly payments automatically transferred to the lender, the lender may skip the next automatic payment.

To address both problems, the borrower must include instructions with the extra payment to specify how the lender should apply the extra payment.

How to Make an Extra Payment

Follow these four steps to make an extra payment on your student loans.

1. Make all required payments by the due date.
2. A day or two after you make the required payments, make an extra payment.
3. If paying by check, write the loan id number and "payment to principal" on the check. If using the lender's online interface, apply the extra payment to the loan with the highest interest rate.
4. Include a cover letter with instructions on how to apply the extra payment.
   • The cover letter should specify that the extra payment should be applied to principal balance of the loan with the highest interest rate. If possible, the cover letter should specify the loan id number of the loan with the highest interest rate.
   • The cover letter should also specify that this payment should be considered an extra payment and not as an early payment of the next installment.

It is very important to include a cover letter if you are mailing the extra payment. If you don't provide the lender with instructions on how to apply the extra payment, the lender can apply it arbitrarily. For example, the lender might split the extra payment among all the loans, or apply it to the loan with the lowest interest rate instead of the highest interest rate, or apply it to the loan with the earliest due date.

Frequency of Extra Payments

There are two main approaches to making extra payments.

• One involves making small extra payments every month. This is like the mortgage strategy where one makes biweekly payments equal to half of a normal monthly loan payment. This yields 26 payments in a year, instead of 24.
• The other strategy involves making an extra payment that is the equivalent of a full month's payment once a year. For example, you might make an extra payment after you get a bonus or your income tax refunds.

Impact of Making Extra Payments

Suppose a borrower has a $10,000 student loan with a 5% interest rate and a 10-year repayment term. Without extra payments, the loan will be paid off after 120 monthly payments of $106.07, totaling $12,727.86.

If the borrower makes one extra payment of $120 each year, the loan will be paid off after 108 monthly payments of $106.07 and $989.44 in extra payments, a total of $12,445.00, saving $282.86 in interest.

If the borrower makes an extra payment of $10 per month, the loan will be paid off after 107 monthly payments of $106.07 and $1,064.63 in extra payments, a total of $12,414.12, saving $313.74 in interest.