Avoid Student Loan Delinquency and Default

Thanks to recent legislation, defaulting on student loans can not only jeopardize credit worthiness, but also deny the defaulting borrower of Social Security benefits. A recent report reveals some of these major changes and the recent trend in defaults.

The study also segments default by the type of borrower, such as graduate vs. undergraduate students and dropping out vs. obtaining a degree. To see the complete article, click here. To learn more about avoiding student loan debt in the first place, click here.

Government Debt Isn't Rational

When comparing the debt of various governments and taking into consideration the debt-to-GDP ratio, one would rationally assume that Japan would have defaulted on it's sovereign debt by now. The reason is that their debt-to-GDP ratio is one of the highest at a whopping 200%.

But this is another display of non-rational, emotion-driven markets, since it's not the actual ability to repay that matters in the near term -- it's the perception of the ability to repay.

For the rest of this article, click here. For the Elliott Wave Principle, click here.

Alternative Pre-Payment Penalty Calculation

Some loan terms in notes calculate pre-payment penalties in terms of compensating the lender for some of or all of the interest that the lender would have earned if the borrower had not paid down the loan. This protects the lender especially when the borrower is locked in a fixed-rate loan and market interest rates drop.

From the borrower's perspective, it is wise to be aware of these loan provisions and how they can affect the cost of capital. If a borrower is convinced that his loan's rate is locked in at a historically low rate and that the market's interest rates will likely rise, then loans with this type of pre-payment penalty will be tolerable. Otherwise, borrowers should consider this type of pre-payment penalty as an additional cost.

Now, let's calculate this alternative pre-payment penalty.

Formula

Step 1:

Unpaid Principal - Yearly Pay-Off Allowance = Total Pre-Payment Principal

Step 2:

Total Pre-Payment Principal x Note Rate = Annual Interest Amount

Step 3:

Annual Interest Amount ÷ 12 months = Monthly Interest Amount

Step 4:

Monthly Interest Amount x Penalty Term = Pre-Payment Penalty

Example

Assume the following loan terms:

Unpaid Principal Balance: $150,000

Yearly Pay-Off Allowance per loan agreement: $20,000

Loan's Note Rate: 6.25%

Pre-payment Penalty Term: 6 months of interest

Calculate the following:

Step 1:

$150,000 - $20,000 = $130,000

Step 2:

$130,000 x 6.25% = $8,125

Step 3:

$8,125 ÷ 12 months = $677.08

Step 4:

$677.08 x 6 months = $4,062.48

Prepayment Penalty = $4,062.48

Common Lender Pre-payment Fee Miscalculation

It's amazing to me how some lenders will enforce loan terms that are not a part of the loan agreement or note. Worse than that, many borrowers are unaware that the lender is cheating them. A common example occurs when lenders miscalculate pre-payment penalties at the borrowers' expense.

So what's the problem? The problem is a lack of understanding of simple algebra. Here's an example: Let's say you have a mortgage of $100,000 and you want to pay down the balance (principal reduction) by mailing a $20,000 check. However, you must also pay a 3% pre-payment penalty according to your loan agreement. Many lenders will unjustifiably demand that you owe them a pre-payment penalty of $600. It sounds right because 3% of $20,000 is $600, but it is completely wrong.

The correct way to calculate a pre-payment penalty is to first realize that the pre-payment penalty is included in the $20,000 check and the rest of the $20,000 will go towards paying down the loan. The portion of the $20,000 that is the pre-payment penalty must not be used in calculating the pre-payment penalty itself. Otherwise, you're being penalized for paying a penalty.

The equation is as follows:

Pre-payment penalty + Principal Reduction = Check you're mailing

In mathematical terms, that;s:

Principal Reduction x(pre-payment penalty rate/100) + Principal Reduction = Check you're mailing

Substituting the numbers from our example:

Principal Reduction x (3/100) + Principal Reduction = $20,000

Simplifying:

.03 x Principal Reduction + Principal Reduction = $20,000

Simplifying further:

1.03 x Principal Reduction = $20,000

Now, solving for “Principal Reduction”, we get:

Principal Reduction = $20,000/1.03

Which is:

Principal Reduction = $19,417.47

Which is rounded down to the nearest penny in favor of the lender. This means that the pre-payment penalty is $582.53 ($20,000 - $19,417.47). Originally, the lender was demanding $600, which is $17.47 too much.

To keep it easy, the equation is:

Principal Reduction = Check you're mailing/(1 + (pre-payment penalty rate/100))

Sometimes this is hard to explain to someone in a bank, but there is a clever way around having to teach a bank employee basic algebra. Try simply writing two separate checks and on the memo portion of one check write “principal reduction”, and on the other write “pre-payment penalty”. Include a letter explaining that you want to pay down your loan by $19,417.47 and that you've already calculated the pre-payment penalty for them.

They'll understand this, won't question you, and you'll save $17.47 every time you do this! Of course, with larger loans or higher pre-payment penalties, you'll save even more. I hope this helps!