Woman using laptop in cafeWhile federal student loans can sometimes cause confusion, one would think making your payment is the easy part. But in fact, one of the most frequent topics student loan borrowers ask for help with is managing their repayment. Understanding how student loan payments are applied can help you strategize a repayment plan that can save you thousands over the life of the loan. Here are five facts about your federal student loan payment.

Fact #1: Payment application is dictated by federal regulation

Apart from payments made by the military, all student loan payments must be applied the same way.  First, the payment covers any outstanding fees, such as late fees; then, it goes toward any accrued interest as of the date the payment was received by the loan servicer (this is the entity collecting your loan payment); and finally, if there are any funds left over, the rest goes to the principal. So, if you have a payment of $100 and on the day the loan servicer receives it you owe no late fees and $30 in interest, the interest will be paid down to zero and the remaining $70 will be taken off of your principal balance. You cannot request to prepay interest (I’ll talk more about this in a moment) nor can you request to pay principal before paying your interest.

Fact #2: Paying extra results in a “paid ahead” status

If you pay extra beyond your monthly student loan bill, and you don’t specify otherwise, federal regulations require that the excess amount be applied to the following month’s bill. The payment will be applied to next month’s principal and interest exactly as described above. You cannot prepay interest that hasn’t accrued yet. And your loan servicer must apply your payment as soon as it’s received. When you pay extra beyond your monthly payment, that payment is marked as “paid ahead” status. If you’re pursuing Public Service Loan Forgiveness (PSLF), a loan forgiveness program for federal student loan borrowers who work in government and 501(c)(3) organizations, any payments in “paid ahead” status made 15 days before the due date (or earlier) don’t count toward the 120 payments you need to achieve PSLF. If you find yourself in this situation, call your loan servicer. They can often reapply all paid ahead payments so that most, if not all, will count for PSLF purposes.

Fact #3: Paying extra can save you money over time

Understanding how interest accrues and how payments are applied on your student loans can make a big difference in helping you strategize how to pay them off efficiently. Interest on the vast majority of student loans (all federal, most private) accrues on a daily basis based on your balance that day. The interest is not added to the principal (also called capitalization) but sits in its own field on your account.  As I mentioned earlier, when you make a payment, the money goes first to fees (if there are any), then accrued interest, then principal.

Here’s an example of what that can look like. Let’s look at a loan with a $10,000 balance on May 1st and an interest rate of 5%. Let’s assume that all interest has been satisfied up until May 1st and there are no fees.

  • On May 1st, there is $10,000 in the principal field and one day of interest, which equals $1.37 in the interest field. The interest calculation is:

Principal Balance ($10,000) x Interest Rate (5%) / 365.25 (Days in the Year Including Leap Year)

  • On May 2nd you have $10,000 in the principal field and $2.74 in the interest field.
  • On May 30th there is $10,000 in the principal field and $41.10 in the interest field. On that day, the loan servicer receives a $100 payment from you.
    • First, they will pay off that $41.10 of interest
    • Then, they will then take the remaining $58.90 and pay off that amount from the principal balance
    • Now the interest balance is $0 and the principal balance is $9941.10
  • On May 31st, the principal balance would be $9941.10 and the interest balance would be $1.36.

You are now accruing less interest because the balance is slightly smaller. If you had made a $500 payment, the $41.10 would still have been paid first, but $458.90 would have come off the principal balance, resulting in a $9541.10 balance and only $1.30 accruing in interest the next day. You also would have pushed the due date back by four months and not have had a payment due until October. If you choose not to pay until that time, the interest will continue to accrue daily at $1.30 per day and you would have approximately $195 to satisfy in interest come October. You would still only be due $100, but none of that payment would go toward your principal.

Paying Extra Can Save You Money Over Time

Fact #4: Sometimes accrued interest can capitalize

There are several situations that can cause the interest in that accrued interest field to be added to your principal balance, a practice called capitalization. In general, any time a loan goes from a non-repayment status, such as an in-school deferment or forbearance, to a repayment status, any outstanding interest is capitalized. It can also happen when you change repayment plans or go into default. This will also likely cause your payment to increase, as you’ll now be accruing interest off a higher balance.

To use our above example of a $10,000 loan at 5% interest, if you were to use a forbearance (a period of non-payment) for 5 months rather than make payments, approximately $205 in interest would accrue and, if unpaid, be capitalized. The new balance of $10,205 would accrue interest at almost $1.40 per day rather than the $1.37 it was accruing previously. This may seem like a small amount, but over time, especially with higher balances, this increase can really add up. This is why I almost always advise borrowers to pay the interest while they are in school or during forbearance or deferment periods. You can work with your loan servicer to do that.

Fact #5: Sometimes it’s okay if your payment amount is less than your accrued interest

If you are pursuing PSLF or other forgiveness programs, it generally does not make any sense to pay extra towards your loans. Most borrowers hoping to receive some loan forgiveness utilize an income-driven repayment plan that can, for those with low incomes, result in a payment that does not satisfy the monthly interest. This results in a loan that is not getting any smaller but is in fact increasing from month to month. While this can cause anxiety, if you are sure you qualify for a forgiveness program, paying extra towards the loan will not benefit you in any way.  If you aren’t sure if you will be pursuing one of these programs, I recommend putting the extra funds in a separate bank account, so you can apply them to your loans if you do at some point decide not to continue pursuing the forgiveness program.

Betsy Mayotte, President and Founder, The Institute of Student Loan Advisors

Betsy is the President and Founder of The Institute of Student Loan Advisors (TISLA). She has been working in the student loan industry doing compliance and advocacy work for over 20 years and has helped thousands of borrowers with their student loans. She is regularly quoted in the media on student loan issues and was a frequent contributor to U.S. News and World Report’s The Student Loan Ranger.