Do Student Loans have Prepayment Penalties? [Explained]

Looking to get rid your debt faster? Look into prepayment of your student loans as an option. Here is an indept of prepayment of student loans and how to request for one. Discover the advantages of taking prepayment as an option.

Updated by Kirtika Acharya on 13th December 2019

Prepayment is a great way to tackle your debt. The payments being made each month is targeted towards the interest and not the principal amount. The biggest problem with prepayment is the fact that most lenders have prepayment penalties because of which most borrowers are discouraged to make these prepayments towards their student loans.

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What is Prepayment?

All education loans, involving federal and private student loans, allow for penalty-free prepayment. This indicates that you can make extra payments to lower the balance of the loan, or even pay off the whole balance early, without having to pay an additional fee.

When a lender receives payments on a loan, the payment is applied first to late charges and collections 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 portion as specified in the repayment schedule) is considered a prepayment.

Why Prepay?

Prepayment can save you money by paying off your loan faster and by reducing the total interest paid over the lifetime of the loan. Since the loan balance comes down, more of your subsequent monthly payments towards the loan balance and less toward interest.

When you have more than one loan, you should apply prepayments toward the high priced loan first (the loans with the highest after-tax interest rates). This strategy will save you the most money.         

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. 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 loans. Otherwise, the lender will treat it as though you had paid your next installments early, and may delay the next payment due date(s) as appropriate. 

If you have a number of loans with the same lender, you may wish to specify that the extra payment 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.

Prepayment Penalties are not Permitted to on student loans

Federal law put the bar on 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 Act (HEOA) amended the Truth in Lending Act  (TILA) in 2008 to ban prepayment penalties for private students as well.

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.    

It is better to have the prepayments applied to the loan with the highest internet 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 borrower’s loans.

Generally, If a borrower has both federal and private student loans, the prepayment should go toward private loans, which typically have a higher interest rate than the federal loans.

Worried about your college tuition? Learn more about student loans

How Paying Extra Affects Your Loan?

Paying extra each month (or making an extra payment per year) will pay off the loan sooner and reduce the total interest that would have added up.

Direct Subsidized Loans and Perkins Loans do not accrue any interest while enrolled in school at least half-time and during the grace period. If you pay off the balance before the grace period ends, you’ll repay just the amount borrowed, plus any loan fees. That would make the loan interest-free.