Allocating student loan repayments can make a huge difference in eliminating debt.
How important is payment allocation? If two borrowers had identical loans, identical payment amounts, and made payments at the same time, the borrower whose payments were misallocated could easily spend thousands more than the borrower with a smart allocation strategy.
Today, we’ll be looking at the distribution of payments from two angles:
- Ensure payments count as principal and not interest, and
- First identify opportunities to eliminate problematic debts.
A smart allocation strategy doesn’t necessarily mean spending more money each month. Instead, it simply ensures that your debt is eliminated as quickly as possible.
The standard rules for payment processing
When you make the minimum monthly payment on your student loan, you don’t have to make any allocation decisions.
Whether your loans are federal or private, the minimum payments are distributed in the same way.
First, part of the payment is used to pay off any outstanding late fees on your loan account. Second, the payment is used to pay off the interest accrued the previous month. Finally, the remaining funds reduce your main balance.
The key takeaway is that borrowers cannot call their lender and request that 100% of next month’s payment be applied to the principal balance.
Paying extra is smart
For borrowers early in the repayment process, a monthly payment could consist almost entirely of interest.
It is the preference of the lender. Lenders make money on interest and fees. When the principal balance is lowered, the borrower is only paying back the money he borrowed. If a borrower is paying high interest and barely touching the principal balance, the loan can last for decades, with the borrower paying far more than they originally borrowed.
I’ve seen cases where a borrower took out $60,000 in student loans, paid a total of $80,000, and had a balance of $50,000. Factoring in loan balance growth during studies and other deferments, the numbers can quickly get crazy.
Paying the slightest extra can make the difference. For borrowers at the start of repayment, paying $10 more can be like making a double payment.
Sherpa tip: Paying extra is not always the best idea. Sometimes, building an emergency fund or saving for retirement is the best choice.
Likewise, if you are on your way to federal student loan forgivenesspaying extra could mean less debt is forgiven.
Allocation of payments to principal rather than interest
Extra payments are almost always made in an effort to pay off the loan faster.
In many cases, lenders and servicers will take the extra funds and immediately reduce the loan principal balance. This is usually the desired approach.
However, some lenders place the loan in a “prepaid” status. Instead of immediately crediting the borrower, the lender uses the additional payment to count toward future payments. In other cases, the lender will use the additional amount to reduce the minimum payment due for future payments.
It is relatively simple to avoid these problems. If you pay $100 more, your main balance should drop another $100. If not, call your lender and ask for an adjustment.
Once you’ve settled things with your lender or repairer, no further effort is required. That said, it’s still a good idea to check your statements and balance history from time to time to make sure everything is being handled correctly.
Further reading: More advice on make payments count as principal instead of interest.
Choice of payment allocation
Most borrowers have more than one student loan. For some borrowers, this means multiple loans from the same lender. For others, it means multiple lenders. Many of us have multiple loans with multiple lenders to manage.
If you are going to pay extra, the critical detail is which loan you choose to attack.
Many borrowers opt for the loan with the highest interest rate. Others choose the loan with the smallest balance. Some choose to repay loans with a co-signer first.
Of the many repayment strategies available, most borrowers will benefit from tackling their high-interest private loans first.
There is no right or wrong order for repaying your student loans.
Sherpa tip: Even if you pay extra each month, it doesn’t hurt to ask for lower monthly payments for your student loans.
Lowering the minimum monthly payment on a low interest loan frees up more money each month to attack the high interest loan.
Target one loan at a time
Allocating extra payments to a single loan is the perfect way to eliminate debt.
To be clear, you must make minimum payments on all your loans. However, the additional payments are all directed to one loan.
I often see borrowers who pay a little more on all their loans. That’s not a bad strategy. This approach is certainly better than simply paying the minimum on all loans. However, this is not the best strategy.
By targeting a single loan, it is eliminated faster. This means it drops on your credit report faster and opens your budget faster. At this point, you can move on to the second loan.
I call paying a little extra on all loans the error of the responsible borrower. It could easily be a $1,000 mistake.
Reallocate previous payments
If your lender processes your extra payment incorrectly, you can usually sort things out with a quick phone call.
Things are much more complicated if you want to change years of payments. However, it is still possible.
For example, some federal borrowers who made payments during the Covid-19 payment pause received emails offering the option to reallocate their payments. This is a great opportunity to ensure payouts are applied using your ideal strategy.
Additionally, borrowers who made payments during the break can also request reimbursement of payments made. Borrowers can take this check and make a new payment for a single loan. This extra step essentially repurposes things if your repairman isn’t willing to help.
There is no “best” allocation strategy
A borrower concerned about interest expenses will want to pay off the loan with the higher interest rate first.
someone who wants buying a home may find that eliminating the loan with the smallest balance is the best approach.
Other borrowers may want to use one of the many different strategies available for loan repayment order.
Because there is no definitive best redemption order, there is no ideal allocation strategy. Therefore, borrowers should not assume that their loan servicers will handle things the way they want.
Once you’ve chosen the strategy that meets your needs, make sure your lenders and servicing agents follow your instructions.