Difficulties in having payments properly applied to a loan balance are among the most common complaints the Consumer Financial Protection Bureau receives about student loans, according to the bureau’s second annual report on the topic.
Paying extra toward the principal is a common way to save on accrued interest and to shorten the life of a loan. But without explicit instructions, extra amounts may be allocated incorrectly.
Borrowers sending in extra payments, however, may find that the money is not allocated in the way they intended. Sometimes, borrowers told the bureau, they received a notice putting them into “paid ahead” or “advanced payment” status.
Complicating the problem is the fact that borrowers typically have several loans, with different balances and interest rates, which are bundled together in one “billing group” with a servicer, who collects a single payment and applies it to the individual loans. Just how much benefit a borrower gets from the extra payment depends on how the servicer applies the money. Savings will generally be greater, for instance, if the entire extra payment is applied to the loan with the highest interest rate, rather than being prorated to each loan individually.
The difference in savings can be substantial, as shown in this example where a borrower makes an extra $100 payment every month over the life of her loans.
What should a borrower do?
Here are some questions to consider when making extra payments to reduce your student loan balance:
■ Is there any penalty to prepaying my student loans?
No. Private lenders are barred from penalizing students who make extra payments or pay off their loans early. (Federal loans do not have prepayment penalties either, Mr. Chopra said,)
■ How can I make sure my extra payment is allocated properly?
Send written instructions to your servicer; otherwise, the servicer may choose how to allocate the extra money. The bureau created a sample instruction letter, directing the servicer to apply extra payments to the loan with the highest interest rate first, which is generally the best option for most borrowers.
When I send in extra money on my mortgage payment, it automatically goes to pay down principal and is never counted as an “advanced payment” on next month’s bill. I thought that was standard practice, but apparently not.
Pauline Abernathy, vice president of the nonprofit Institute for College Access and Success, said the report suggested there should be a uniform policy, outlining the way payments were applied. “Why force the borrower to specify?” she said.