Pay Extra on Your Student Loans or Use a Shorter Repayment Term?
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By Mark Kantrowitz

November 3, 2020

Which is a better way to pay down your student loan debt quicker? Paying extra on your student loans or choosing a shorter repayment term? The key differences between the two methods are flexibility and cost.

These differences also apply to mortgages and other types of debt, not just student loans.

Paying More Is Like Having a Shorter Repayment Term

Payments on a student loan are first applied to late fees and collection charges, next to the interest that has accrued and last to the principal balance. So, paying more on a student loan pays down the principal balance quicker.

A shorter repayment term increases the amount you pay each month. If you have a longer repayment term, but pay the same amount as you would have paid on the shorter repayment term, you are effectively repaying the debt under the shorter repayment term.

For example, if your student loans are in a 20-year repayment term, but you increase the monthly loan payments to be the same as they would have been under a 10-year repayment term, you will pay off the debt in 10 years.

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Differences between Paying More and a Shorter Repayment Term

So, isn’t paying extra on your student loans the same as using a shorter repayment term?

Yes, but there are some subtle and important potential differences.

  • Prepayment penalties. Some types of debt will charge a fee if you make extra payments on your loans or pay off the debt quicker. Federal and private student loans, however, do not have prepayment penalties as a matter of law.
  • Refinancing may yield a different interest rate.  When you consolidate federal loans, the new interest rate is the weighted average of the current interest rates, rounded up to the nearest one-eighth of a percent. This can slightly increase the cost of the loan. When you get a private refinance, the new interest rate is based on your current credit score. If your credit score has improved, you may qualify for a lower interest rate. In addition, the interest rate on a fixed-rate private student loan may depend on the length of the repayment term, with a shorter repayment term yielding a lower interest rate than a longer repayment term.  For example, increasing the repayment term from 5 years to 10 years can yield an interest rate that is 0.5% to 1.5% percentage points higher.
  • Flexibility. A longer repayment term yields a lower monthly loan payment, thereby improving the borrower’s cash flow. This gives you the flexibility to pay a lower amount without having to change repayment plans or refinance the loans. You can choose to make extra payments on the student loan, but can stop doing this if your financial circumstances change. A shorter repayment term forces you to make the higher loan payment every month.
  • Rigidity. Most fixed-rate private student loans do not allow changes in the repayment term after the loan is made. The interest rate is based, in part, on the length of the repayment term, since the lender’s cost of funds increases with a longer repayment term. (There may be more flexibility to change repayment terms with a variable-rate private student loan, since the spread stays the same as interest rates rise and fall.) This means that the only way to change to a longer repayment term is to refinance the loan. The prevailing interest rates when you refinance may be much higher than they are now. In contrast, federal student loans let you change the repayment term at any time without requiring a refinance.
  • Eligibility. If you need a lower loan payment because you lose your job, you might not be able to qualify for a refinance. Lenders consider the duration of employment with your current employer when deciding whether to approve a private refinance.
  • Timing. Interest rates may change. Refinancing now lets you lock in the current low interest rates as a fixed rate. If you seek to refinance later to get a lower loan payment, interest rates may have increased in the interim. So, even though refinancing to a longer repayment term now may yield a slightly higher interest rate, this interest rate may nevertheless be lower than the interest rate you could get if you refinance in the future.
  • Locking in a low interest rate. If you can get a low fixed interest rate, it may be beneficial to lock it in for a longer repayment term, stretching out the loan for as long as possible. You can then put the extra cash into investments that pay a better return or into paying off higher interest rate debt.

Thus, the tradeoffs are that a shorter repayment term will yield a quicker payoff and a lower interest rate than a longer repayment term, but it will have a higher monthly loan payment and less flexibility to fall back to a lower monthly loan payment. The shorter repayment term will require more cash flow to repay the debt quicker, but it will free up more cash flow later after the debt is paid off.

Keep in mind that refinancing federal student loans into a private student loan means you will miss out on federal student loan benefits. These include income-driven repayment plans, potential for student loan forgiveness, generous deferment options, and a death and disability discharge.

Cost Tradeoffs

Paying extra on a student loan won’t affect the interest rate, but consolidating or refinancing the loan will. But, refinancing a private student loan to obtain a longer repayment term will increase the interest rate. So, choosing to refinance to a longer repayment term but making the same payment as was required under a shorter repayment term may cost more than sticking with the shorter repayment term.

For example, suppose you refinance a 3.5% fixed-rate $30,000 loan with a 10-year repayment term to a 3.75% fixed rate loan with a 20-year repayment term. The 10-year loan had a loan payment of $296.66 per month, yielding total payments of $35,598.86. The 20-year loan has loan payments of $177.87 per month and total payments of $42,687.55. If you make the same monthly loan payments as were required on the 10-year loan, the total payments will decrease to $36,113.56, saving $6,573.99. So, paying extra still saves money compared with the longer repayment term. But, the slightly higher interest rate means that you will pay $514.70 more than you would have paid on the 10-year loan.

Most of the difference in the loan payments is due to the changes in the repayment term, not the interest rates. However, choosing the longer repayment term for the added flexibility will cost you a few hundred dollars.

The student loan interest deduction lets borrowers deduct up to $2,500 in interest paid on federal and private student loans on their federal income tax return. The amount of interest that accrues and is paid each year increases with a longer repayment term, since the loan balance is sustained at a higher amount due to the slower repayment trajectory. One also gets to claim the student loan interest deduction for more years, unless your income increases beyond the income phaseouts. However, the deduction merely provides a small discount on the interest paid, which is still higher than the amount paid under a shorter repayment term.

Nevertheless, the total student loan interest deduction is similar for borrowers who choose a shorter repayment term and for borrowers who choose a longer repayment term but pay the same monthly loan payment.

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Paying Extra Requires Discipline

Very few borrowers who choose a longer repayment term, intending to make extra payments, succeed in doing so. Paying extra each month requires discipline.

It is too tempting to spend the extra money instead of paying down the debt. Even if you start off paying extra on the loans, you will struggle to restart the higher loan payments after the first time you need the extra cash flow. Or, you’ll pay less than you were paying previously.

Making the higher loan payments mandatory provides a psychological benefit. If the loan payments are automatic, you’ll find a different way to deal with a shortfall in your monthly budget.

So, before you choose a longer repayment term, ask how likely you are to make the larger loan payments if they are optional?

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