How Do Extra Payments Get Applied to My Loan? – Money Mailbox

by David Ning · 5 comments

Gerad wants to know the best way to handle extra payments to his loan servicing company.

I have a question about my private student loan. Most of my loans are federally backed and I have consolidated them. However, I have one loan, which was private that I was not able to consolidate. Currently, I am paying about double on this loan so I will be able to retire it at about the same time as my consolidated loans. My question is how to allocate the extra I am paying on this loan every month. I know normally you would want all the extra to go towards principal. However, because this is a student loan, I will get some of this money back on my tax return (although I am not exactly sure how this works, i.e. is it a dollar for dollar return?) So maybe it is better that I let them allocate the extra the way they would do it, if I don’t tell them to put the extra on the principal, i.e. I end up paying more interest. Currently the rate is 3.85% but I think it will fluctuate. I am scheduled to pay it off in 20 years but I am trying to pay it off in 10 years. Do you have any thoughts on what is the better way to allocate the extra I pay every month? Thank you.

There really isn’t an automated way to make sure your extra payment gets applied to the principle, but you can get this accomplish pretty easily. All you have to do is just call. Yup. Call the loan company up, and ask them exactly how extra payments get applied. Most likely, they will tell you that it will be applied to the principle anyway, but there are some shady practices who will hold onto your extra payments and apply it as your next minimum payment. You don’t want this, so call to make sure.

Getting a Tax Break is Not Free Money

Thinking that you are actually getting free money from the government by having a loan is a common misunderstanding with loans. The bottom line is this. The more interest you pay, the more money you pay out. Most people can get a tax reduction from the interest of student loans, but it just amounts to a portion of the interests that is incurred. For example, let’s say I paid $5,000 worth of interest this year due to my mortgage. Since mortgage interest are tax deductible, I will be able to deduct $5,000 from my ordinary income. At a tax bracket of 25%, that’s a savings of $1250. Once you do the math, I still paid $3,750 out of pocket. If my mortgage interests turned out to be $2,000 instead, I would pay $1,600. There are other factors, such as standard deduction vs your itemized deductions, that will make the true deductions even less. But basically, the tax deductions does not mean you are getting more money, ever.

Having said that…

Everyone in the country thinks about whether they should make extra payments at one point or another. Many will tell you that a 3.85% interest rate is very low and you should therefore use your extra cash to invest rather than pay it off. Many others will tell you that being debt free far outweighs the minor opportunity of extra returns since investing is not guaranteed. At the end of the day, what will ultimately work best is all based on your personality. Are you a risk taker? How do you feel about your debt? Can you avoid emotional investing, which kills investment returns?

My advice is this. Until you know more about yourself, stick with your original plan, and keep paying off your debt as much as you can. Eventually, you will have a much better idea of what you want to do with your payment. While investing is an essential path to take, being debt free will never hurt.

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{ read the comments below or add one }

  • I would not worry too much about the tax deduction verses hitting your principle. If you do the math, it probably would not amount to more than the cost of a few decent dinners.

    At the end of the day, paying down debt is never a bad thing. I would go that route.

  • kt says:

    this is good advice. It is more common sense than ground shaking investment formulas; i am also for the breaking the debt cycle option. Life is much better when you know that the faceless corporations do not own your soul

  • Jodi says:

    I’m always baffled by the fact that EVERYBODY talks about tax deductions when they think of buying a house. “Oh I want to get a mortgage because of the tax deductions.”

    If anything, the Realtor association is really good at marketing, that’s for sure.

  • Jenna says:

    Agreed. Pay of student loan debt ASAP. I can’t imagine carrying around debt for 20 years, good job in setting a goal of halving that.

  • Stephan says:

    i agree that paying off your debt asap will make you feel better. Even if you could get a return higher than 3.85%, its not guaranteed, and you would still be thinking about the loan you have to pay off. For me personally, id rather pay off the debt and get up each morning knowing i dont have any student loans to pay off anymore.

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