Helping Out a Fellow Personal Finance Blogger Understand Her Student Loans

I was shocked when I saw the following tweet by Leslie from 27andFrugal fame:

twitter convo

It immediately caught my attention because amortization loans shouldn’t be paid forward like this, however, when I let Leslie know that was possibly making a mistake she didn’t believe me!  Despite not knowing Leslie I felt it my responsibility to help a girl out and make her a tad more efficient with her money.  After a few emails back and forth I learned that Leslie had a Student Loan:

  • Originally around $28,0000
  • 3.1%
  • 20 years Payments started 1/2004
  • She paid extra at some point but doesn’t entirely remember the details

What Leslie didn’t realize was that she could have saved hundreds if not more in interest over the life of the loan.

What is an Amortization Loan?

Before we attack Leslie’s specific situation we first need to understand what an amortized loan is and how extra payments should be applied.  An amortization loan is,

a loan with scheduled periodic payments of both principal and interest. This is opposed to loans with interest-only payment features, balloon payment features and even negatively amortizing payment features

When you make an extra payment to an amortization loan it is supposed to erase the last principal payments thus erasing the interest associated with those payments.  So lets look at an easy common example before coming back to Leslie’s specific situation.

  • $20,000 Car Purchase
  • 60 Month Pay Off
  • 5% Interest Rate

This leads us to the following amortization schedule:

As you can see we have 60 equal payments but the application of payments were different month to month (you may need to zoom in to see numbers).

What Happens to an Extra Payment to an Amortized Loan

If we add $50 to each payment we get the following results:

  • Saves 7 months of payments and
  • $352 in interest payments.

How? If you look at the Second half of the loan but applying an extra $50 each month

As you see some those $50 are erasing future payments.

Now lets get back to Leslie’s situation.

Adding an Extra Payment to Leslie’s Amortized Loan

It seems that at some point she was sending in her extra payments but her evil student loan company was applying the money to future payments and not on the back end to save Leslie money!  I even got screwed by a loan servicing company once too! Since I can’t fix the past I decided to look at the future, first a reminder about her situation:

Leslies Loan

Her goal was to pay her monthly payment and an $100 extra per month.

Before I update the post with my ultimate out of the box idea I want to hear what you would have told Leslie?

28 Responses to Helping Out a Fellow Personal Finance Blogger Understand Her Student Loans

  1. 3.1% interest that’s tax deductible? Why in the world would anyone pay that off early?

    This is where “frugality” turns into “ignorance”. Debt is a TOOL. It helped her get a college degree and by not paying it off early it can help her grow her net worth substantially.

  2. Great post Evan! Good of you to help her out – she had the best intentions, but didn’t read the fine print. I hate it when lenders do this!

  3. It really doesn’t matter as long as you keep making your monthly payment. Just make sure the principal is reducing by the amount you added on and dont pay attention to your next payment date. Same thing happend with my car loan but I kept making the same payment every month and paid it off.

    • “It really doesn’t matter as long as you keep making your monthly payment.”

      NOOOOOO RThomas That was exactly the point I was trying to make! IT DOES MATTER. She could either pre-pay principal and SAVE on interest or pre-pay the interest.

  4. My brother was stuck with a loan like that for a car. The lender simply were going to get the interests calculated from the loan up front. He had to do some negotiations to get out. Looks like the loan isn’t setup to her advantage and she should sort that out right away.

  5. Most student loans are set up that way. Whenever I make an extra payment I ALWAYS tell them to apply to principle because they do it exactly as they have done to Leslie. I just make a completely separate payment different from my regular payment and have them allocate it that way. Otherwise, they milk you for interest. I had a 7% interest on my old student loan and I’ve paid more than the original loan in interest before I realized that this is how the payment structure it.

  6. I’m surprised her student loan holder is applying additional payments to future payments. I know that when I make additional payments they apply it to the principal. I would definitely advise her to speak to a customer service rep about what options she has to pay off the loan quicker and save on total interest. They may be helpful. That would be my advice. I’m interested to find out what you told her to do.

  7. I would tell her to call customer service and see if they can take all additional payments that have been made and put them toward principal.

    If that isn’t an option, and she isn’t actively trying to pay off this loan….heck, don’t pay it for 2 years and put that money she would have paid monthly for it and tack it on to another debt!

    FWIW…my little student loan is structured this way. I have been making payments, and they take $2 of each $100 for interest. I should call, but for the $2, it isn’t worth my time at this point.

    • “don’t pay it for 2 years and put that money she would have paid monthly for it and tack it on to another debt!”

      I don’t have any other debts but I do like this idea to stock my savings!

  8. Sometimes it can be a challenge to get a lender to apply an extra payment to principal. My credit union tried to tell me they were not allowed to do so when I went in to pay off a small home equity loan. I pointed out they had no problem accepting extra principal payments on the five-year car loan I retired in 18 months, and eventually they folded. But it sure took some doing, to say nothing of “you’ll be talking to the banking commissioners” threats.

    If her lender won’t take early principal payments, then she’d be better off using the extra money to pay off any other debt or putting it in savings. Over 20 years, $100 a month would build up a very nice Roth IRA.

  9. Good thing you caught her tweet. What an odd way to handle extra money being paid. I would die if that happened on the extra principal I pay on my mortgage each month.

    How did she get such a low loan rate? Good for her!

  10. I’m amazed how many people don’t understand the amortization of their loans. If they pay off more than their monthly payment early on, they’ll always save many months worth of payments! I try to teach this wherever I can. Great post.

  11. After talking to Leslie I gave her a couple options all picked up by my SMART SMART SMART readers (which pumps me up), but my favorite one would be:

    Stop making “monthly” payments and for the next 2 years put her $280 directly to principal.

    This would provide close to $6700 payments PURELY to principal! And then when she finally catches up to her pre-payments she can do the extra payment on top.

  12. There is 2 issues here. The first, interest rate is low, tax deductible, therefore subsidized. The net cost is probably below 2%, alternative investments could easily exceed that. The second, the additional payments went toward future payments instead of principle. She is not receiving the credit of the additional payments quite as intended.

  13. Thanks for a great post. Seems like there is a lot of questions on if interest rates can be tax deductible. I’m all for paying off any loan as soon as possible.

  14. I did this on my student loan a couple years ago… and by moving the pay off date, I managed to save hundreds of dollars!

  15. Not fair. My student loans are 6.8%. If I went to school this year, they’d be way lower.

    Anytime I pay extra, the payments are automatically applied evenly to everything *outstanding*, interest first. But early payments are never applied to future payments. I didn’t know that happened – thanks for pointing it out, I’ll know to keep an eye out for that in the future.

    (I do make them reapply the payment to my loan with higher interest, rather than leaving it applied evenly though.)

  16. The tax deduction for interest is, in my opinion, a distraction from saving. Folks getting a bigger loan, any kind of loan, and hoping they would get interest deduction on their tax return are deceiving themselves. In 2009, our interest came to be $14,000. After deductions, we got $3,000 back. What happened to the $11,000 we paid in interest.

  17. Evan, this answers making an extra payment, but here is my sitch:

    I have a 20yr loan at 3.49% from undergrad that my parents have been paying down. Now, 10yrs later, my mom has the money to pay off the rest, ($8,000), but I say hey wait, that’s a low interest loan, give me the money and I will put part of it in my Roth and part in my savings and pay it down slowly myself. I have no credit or auto debt, but am paying another grad school loan off myself.

    What do you think we should do – pay it off and be done with it, or continue the schedule (perhaps with some extra payments to principal). ?

  18. Uh, the fact most, if not all student loan interest is NOT amortized, but calculated by simple interest formulas is an indication that you should not be giving financial advice to anyone. She was correct to prepay if she wanted to. Wonderful advice for a mortgage, though. So maybe you should take out some student loans and take a few finance classes before blogging on this stuff.

    How is interest calculated?
    “Interest on all loans borrowed under the U.S. Department of Education’s programs is calculated on a simple daily basis.”

    From: http://studentaid.ed.gov/students/publications/repaying_loans/2009-2010/repay2.htm

    • First of all I don’t give finance advice. Second of all there is no reason to be an asshole especially when you are wrong.

      Third:
      Amortization is a type of payment schedule not how interest is calculated.

      Try reading a bit further
      http://studentaid.ed.gov/PORTALSWebApp/students/english/OtherFormsOfRepay.jsp

      In fact there is a class action suit against Sallie Mae to have them change the accrual to monthly – against this doesn’t affect the amortization schedule. Much like a 10 year arm is based on a lower interest rate but payments are based on a 30 year amortization payback schedule.

      There really is zero debate about what she should do since it was a discussion of prepaying principal or prepaying interest.

  19. You can call me an asshole if you like, but I’m not the one who went out of his way to give erroneous advice to someone on twitter.

    Whether you consider a simple interest loan amortized or not is irrelevant, because they do not work in the way that you have described. Simple loans do NOT use an amortization schedule since they calculate interest daily. So unlike a loan with an amortization schedule, the portion of your payment going toward interest can vary wildly depending on when you pay. You will pay an amount of interest per day depending on the principal amount remaining. This interest amount goes into accrual, and doesn’t gain interest of its own (unless it’s capitalized, which is another matter). When you make a payment, ANY payment, you pay the amount in accrual first, then any remaining money goes to principal. Therefore, paying ahead reduces the amount paid to accrual, and thus takes more off principal, thus further reducing future accruals. There is no such thing as a principal only payment, as there is always something in accrual (unless payments are made on the same day). Moving the payment due date forward does not affect anything, since even if the payer opts to wait on those payments, they are still accruing less daily interest in the interim due to the lowered principal.

    So you are wrong. Period.

    As to your claim of not being a financial advisor – I agree, but that didn’t stop you from giving specific financial advise to an actual person. Go back and read the first part of your post. YOU sought out a girl who you decried as making a mistake, saying you should NEVER pay ahead this type of loan.

    Here’s a primer for you on simple interest. http://www.mtgprofessor.com/a%20-%20amortization/how_does_simple_interest_work.htm

    • First I shouldn’t have called you an asshole, I feel bad about that and it does nothing to further the discussion. I apologize.

      Second, re-read the post I never said Leslie shouldn’t prepay the loan I said she may have been making a mistake as to letting the company incorrectly apply those prepayments.

      Lets first take a look at the end game and then we will get into the details:
      I think we may agree that Leslie’s decision to send in extra payments was probably a good thing. I say probably since I know nothing about her other budgetary concerns.

      Details:
      I was/am focused on the application of those prepayments while you seem to be focused on how I got to my calculations.

      She was prepaying payments, hence, why she could stop making payments today (or when I wrote the post) and not have to make another payment for 2 years.

      They were not posting those payments to the principal portion of her account. The company was just marking her future payment paid so she was still accruing the normal interest.

      I think we can agree up to that point it was the calculations that are providing us with our current discussion.

      If she is working with a simple interest loan then you are right, if she is working with a fully amortized loan (like one of my student loans is) then I was right.

      I found a cool spreadsheet on that site you linked to previously for simple interest that I think restates my point:

      http://www.mtgprofessor.com/a%20-%20simple%20interest%20mortgages/amortizing_a_simple_interest_mortgage.htm

      If the company was properly applying those payments her total interest would have been reduced reverberating throughout the spreadsheet. Rather the company was using her prepayments just as a holder for those future monthly payments and thus she was still accruing those daily interest charges.

      So while you may be correct on the simple interest portion (if she is working with a simple interest loan) we still get down to the basic question of how are prepayments being applied.

      • I appreciate that you are open to discourse. I think you are starting to get it, but you are still off a bit.

        I will caution that there are obviously going to be a few mortgaged student loans, possibly from third parties, but all federal loans (which themselves make up the bulk of student loan debt), and almost all third party loans are calculated by the simple interest method, so when we talk about student loan debt, we have to talk about them in those terms.

        We are definitely in agreement that she should pre-pay, no doubt (and there are exceptions to that as well, such as income contingent payment plans if you are anticipating being in government or non-profit service for 10 years, but that is another can of worms).

        However, it’s clear that you aren’t quite understanding how prepayment in simple interest loans works yet. Whether the loan servicer advances the date or not is irrelevant, as there is no predetermined principal to interest ratio for any payment. Whether a payment is 4 months in advance or 8 months in advance doesn’t matter, you simply pay the amount of interest in accrual on that date, and the rest goes to principal.

        As I stated before, there is no such thing as an interest only payment, except in the case that you make a payment on the same day. There will always be an amount of interest in accrual that will be paid prior to applying the remainder of the payment to principal.

        To see how this works, call up the spreadsheet you posted, and start to place extra payments in any of the dates after day 1. Space them out a few days, you will see then that the accrual amount returns to zero on any day a payment is made because the payment amount was first applied to daily interest.

        Now take off a number of monthly payments to account for those prepayments, and you will see that even though you are still accruing daily interest, the amount is lowered because of the lower daily interest charge due to the lowered principal amount.

        Whether or not there is a lawsuit to prevent this method of payment calculation is moot, as these are the payment terms as they exist.

        If you want my personal opinion, I hate this method, because if you are not careful, you can end up paying only interest for the life of the loan if you fall behind. If you always pay early though, you can come out ahead. Actually, if you only pay on time, but you make one, early payment, you will still come out ahead, but not by much.

  20. Financial aid to students is an integral and necessary part of their educational plan. Over the course of their path to graduation debt will continue to grow causing increasing stress and diverting crucial focus away from their studies. It is extremely important that students establish a sound financial plan as well as an educational plan to guide them to their goals.

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