You may think that paying off your student loans early is a good idea. Your career has taken off, and you now have enough money to settle your student loan debt. During the student loan consolidation process, you learned that the longer you keep the loan, the more interest you could end up paying, so you decide to “prepay” your loans. It seems like a smart financial move. Think of the hundreds or even thousands of dollars you could save in interest payments. Before you start prepaying your student loans, make sure that there aren’t any penalties for paying back that money early.
What Is a Prepayment Penalty?
A lender does not loan money to a borrower because he feels sorry for that person’s financial situation. A lender is in the business to make money. One way he makes that money is through the interest rates he charges. The more interest he charges, the more money he ends up making.
When you agree to consolidate your student loans, you sign a contract to extend the life of your loan for a certain number of years. As you extend the loan period, interest payments begin adding up. The lender is counting on receiving those interest payments, which adds to his bottom line. If you pay your loans early, the lender will not be paid that interest. Think of all the money the lender ends up losing.
To insulate him from that risk, a lender may decide to charge a prepayment penalty. The penalty could be the amount of interest, or a portion of the interest, that you would have paid had you stuck to the terms of the loan. A lender may look at the remaining life of the loan to see if a penalty is even necessary. If you have only a short time left on the loan, lenders may be inclined to waive the penalty altogether.
A prepayment penalty will not come as a surprise. When you sign your consolidation papers, the penalty should be clearly stated. The good news is that the majority of student loan lenders no longer charge prepayment penalties, so it is important to shop around.
Federal Loans Do Not Carry a Penalty
The Higher Education Act of 1965 eliminated prepayment penalties on federal student loans. It does not matter if you have a Stafford Loan, Perkins Loan, or PLUS Loan. You will not be charged any penalties if you decide to prepay federal loans. If you do decide to prepay, you will need to explicitly tell your lender to use this money to reduce the balance of your loan. Otherwise, the lender will automatically use this money to pay next month’s installment.
Private Loans and Prepayment Penalties
Years ago, it was common for private lenders to charge prepayment penalties on private loans. As competition in the private student loan market ramped up, a few lenders decided not to charge these penalties. When a student had a choice between borrowing from a lender who didn’t charge penalties and borrowing from a lender who charged penalties, it was obvious who he would pick. Lenders definitely made money charging prepayment penalties. However, the business and subsequent profit they lost by charging these penalties was too much, so competition basically eliminated them.
Today, private lenders are no longer charging these penalties. In fact, it is the law. Congress passed The Higher Education Opportunity Act of 2008 and changed the Truth in Lending Act. The law bans any penalties or fees associated with paying back your private loans early. However, if you consolidated your private loans prior to 2008, there may still be penalties involved. You will need to read the fine print.
It does not matter whether you are consolidating your private loans or your federal loans. Always do some due diligence, and ask the lender if there are any prepayment penalties involved. Yes, the law states they cannot charge these penalties. However, you want to make sure that they have not just renamed another fee to get around this law.