Student Loan Borrowers Who Prepay Suffer

NEW YORK (MainStreet) — Many borrowers strive to prepay their mortgages or car loans. Student loans can also be prepaid. But while mortgages and car loans are prepaid without problems, the prepayment of student loans turns the simple into the complex. The Consumer Financial Protection Bureau (CFPB) has received many complaints about the process.

Every year mortgages, car loans, and other consumer loans are prepaid by paying the current monthly payment due plus the principal of the next one or two months. Occasionally, a lump sum payment is made that will pay off several months or even a year's principal in advance. Normally there is no problem with this process. But in the area of student loans there seems to be.

The CFPB's Student Loan Ombudsman, Rohit Chopra addressed this issue in his October 16 blog entry. "Since many borrowers can't refinance, one of the only ways to avoid paying unnecessary interest is to pay their high-rate loans off more quickly," he wrote. "According to the Truth in Lending Act, your lender or servicer cannot assess any penalties or fees if you prepay your private student loan."

CFPB states that the policies of private student lenders and loan servicers are confusing borrowers who want to prepay their loans.

One problem is those with multiple loans with the same loan servicer - the company that does the monthly billing. Absent specific instructions, the servicer will allocate the payments to the excess of the amounts due.

"Leaving this decision up to them isn't always the best choice," the The CFPB advises. "Your student loan servicer should listen to your instructions about which loan your additional payment goes toward when you submit your payment."

But what CFPB does not state is that there are two problems with prepaying student loans.

One is what they describe. However, there is another. The prepayments are simply used to advance the next payment due date. They are not applied to reduce the principal. The advance is the default application of the payments.

The root of the problem is that the loan servicer does not provide clear cut instructions on how to prepay the loan. There is nothing to which one can refer easily as to what is necessary to make prepayments. There is no contact information, no procedure, nothing at all to guide borrowers.

Only recently have student loan companies advised customers urging them to prepay loans if possible. Most likely this is in reaction to the criticism they have been getting the past few years. But they still do not provide explicit instructions on how to do so or why.

"Basically you have to tell the lender how to do this," said Chip Law, an independent educational consultant with Educational Avenues, an academic advising firm in Charleston, S.C. "Very often the lenders just advance the payment date instead of prepaying the principal - so you are just changing the date the next payment is due. The principal amount is not reduced at all."

"It is clearly to the lenders' advantage to make the prepayment procedure obscure," Law added. "There is no standard or code among lenders,of which I am aware, to explain to borrowers how these extra payments are to be applied. People who are used to prepaying mortgages to reduce the principal think their prepayments of student loans will automatically be applied the same way."

The CFPB provides sample instructions as to what the borrower should tell the servicer. For example, the CFPB says lenders should be directing extra payments toward the highest-rate loan. "Helpful servicers," they say, "will generally accommodate your request."

But once again, CFPB fails to address the problem of prepayments not reducing principal but instead advancing the payment date. While CFPB's advice is sound it is incomplete.

"For most borrowers, it makes sense to direct any extra payment toward your loan with the highest interest rate – this is the fastest way to save the most money over the long term," CFPB says. "For other borrowers, saving the most money might not be their main goal. You may be interested in paying extra each month on certain loans in order to improve your credit profile, qualify for a mortgage, or eliminate a monthly bill. You should weigh all of your options."

Why CFPB does not address the advanced due date issue is unknown. Requests for comment were not answered. But until someone codifies this borrowers must be aware that their extra payments will not be applied to reducing the principal unless the lender is specifically instructed to do so - and even then, this is not always a guarantee.

--Written by Michael P. Tremoglie for MainStreet

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