According to the Institute for College Access & Success’ Project on Student Debt, seven out of 10 college seniors graduate school with debt. No one knows better than young jobseekers that paying off students loans is a major priority. So imagine your surprise when you discover that the extra loan payments you have been sending to your loan servicer aren’t helping pay your debt down as quickly as you thought. Unfortunately, that’s a situation facing many student borrowers.
Shady payment handling by servicers
Loan servicers across the U.S. are deliberately misapplying extra loan payments sent by borrowers who intend to pay off one loan over another, according to the Consumer Financial Protection Bureau. A well-meaning borrower might want to pay off their higher-interest loan, for instance, and send extra payments to their servicer to minimize the amount of interest paid. But instead of applying the payment to the loan’s principal, the servicer handles it in a way that prevents borrowers from paying off their higher-interest loans in full — and cuts into their overall savings.
How they’re applying extra loan payments instead
To illustrate the complexity of the repayment process, the CFPB Student Loan Ombudsman’s annual report describes a hypothetical situation in which a recent college graduate begins repaying $30,000 in three private student loans. Each loan has its own interest rate — one is 7 percent, another 9 percent, and the third’s 13 percent. Her total monthly minimum payments for all three loans is a little less than $400. Paying just the minimum, the loans will be paid off in full after 10 years.
After a year, the student decides to begin sending in an extra $100 in order to pay off the loan with the highest interest rate more quickly. Assuming she is paying an additional $100 in principal (the amount you actually borrowed without the interest), sending in these extra $100 payments should help the grad pay down the loans more quickly and help her pay less interest. In all, she’ll save $5,403.62 by the end of the repayment process.
However, the loan servicer has decided to apply the extra $100 payment in another way — spreading it evenly across all three loans. That results in smaller savings for the graduate, but more cash for the lender. Spreading the $100 across all three of the grad’s loans will save her $4,514.98 — or $888.64 less than she would have saved if the extra payment was applied directly to the highest interest rate loan.
Another way loan servicers can apply your extra $100 payments is by prorating it. That will save the borrower $4,613.31. But what exactly does prorated mean? According to Mark Kantrowitz, senior vice president and publisher of Edvisors.com, the concept is technical, but not impossible to understand. Typically, Kantrowitz explains, “When a servicer receives a loan payment, it is first applied to the interest that has accrued since the last payment. Then, any remaining money is applied to the principal balance.”
However, not all lenders play by those rules. Some lenders prorate your extra payments. Lenders who prorate the additional payments apply “the principal portion of the regular payment in proportion to the outstanding principal balance on the loans. Since the principal balance on the higher interest rate loan has decreased, this means more of the regular payments is being applied to the lower-rate loan, which preserves the remaining term of the loan for both loans, instead of paying off the highest rate loan quicker.”
Kantrowitz says the best approach to having a prepayment credited toward a specific loan is to specify which loan should get the prepayment, but it isn’t always that easy.
More borrower-lender issues
Borrowers who send payments with specific instructions on how their extra funds should be applied sometimes get ignored, according the Consumer Financial Protection Bureau. “Even when the payment is accompanied by an explicit instruction… complaints revealed that many student loan servicers elect to apply extra payments as they see fit — and not necessarily in the way that offers the greatest benefit to the borrower,” the bureau says.
Moreover, some consumers who call their lenders to discuss how their payments should be applied are sometimes met with confusion from representatives unable to clearly explain the loan repayment process. Many borrowers say that they’re told their payments are being paid in advance. What does that even mean?
“If the servicer is telling you that you are one year ahead on payments, that means they have been applying your payments as covering the payments required for future months,” explains Steven Ellwell, a certified financial planner at Schroeder, Braxton, and Vog. “They have applied it like you are just paying the scheduled payments early, so in theory you could just stop making payments for a year and still not be late on your student loan payments. This still helps pay off the loan quicker and saves you interest — but not as much as having all the extra payments applied directly to principal.”
“When they say your regular payments are ‘prorated proportionally,’ it means based on the current balances they are splitting up your payment so that some goes to loan No. 1 and some goes to loan No. 2,” he adds.
What to do if your additional student loan payments are being misapplied
Currently, lawmakers are mulling what to do about loan servicers who misapply student loan payments. Until changes are enacted, experts recommend that borrowers explicitly explain — in detail — how they want their payments to be applied to lenders. Though some consumers have reported that their instructions are sometimes ignored, it still pays to ask.
Ellwell recommends including the following information when you speak or write to your lender about how to apply your additional student loan payments: “Please direct my extra payment exclusively to principal of loan No. 2. I do not want to prepay or pay ahead my regular scheduled payments for any future month. I will continue my scheduled payments like normal for future months. This particular payment should not be applied to any interest on either loan No. 1 or No. 2.”