To advance your due date or not

I got one particular thought-provoking comment from yesterday's post from Pat. I'll reproduce it here:

I still don't quite follow. Is it better to check the do not advance checkbox or not? My wife has some federal student loans that I would like to pay extra on each month so that we can decrease the total amount we have to pay over the lifetime of the repayment. Is this not possible with these federal loans?

The tradeoff between advancing your due date and not advancing your due date is an interesting one, and one I want to talk about in more detail. From what I've seen it's very peculiar to even have that as an option on loans, though it may be standard on Federal student loans, or student loans in general.

Before I get started I should come clean. In ranting yesterday I was a complainypants, which is the antithesis of Mustachianism. I want to apologize, especially to the Department of Education, who after all is trying to make my life and the lives of a lot of Americans a little better. Now that that's out of the way, let's talk about tradeoffs.

To answer Pat's second question right off the bat, it is possible to pay off your loan early so that you reduce teh total amount you pay over the lifetime of the repayment. The DoE is giving you extra options and extra decisions to make, which means your payoff is going to be more complicated but will wind up being better for you in the end. Let me try to explain with an example.

Long-Winded Example: Commence!

Let's say I lend $1000 to my friend Victor. Let's also say that I'm going to charge him 1% interest per month (12% per year) on the principal, and I'll compound it every month. But let's also say that I don't care when he pays me — I know he's good for it. So the first month goes by, I charge $10 interest, and add it to the loan. Now he owes me $1010. Then another month goes by, $10.10 accrues in interest, which makes his balance $1020.10. Say at the beginning of the third month, Victor pays me $520.10; now his balance is $500. At the end of the month $5 interest accrues, his balance is $505. And then let's say he decides to pay it off at the beginning of the fourth month, gives me $505, and he's done owing me money.

Over the course of his three-month loan, Victor wound up paying me $25.10 in interest. Most was from the original balance, but that ten cents was from other interest that accrued. Because I trusted Victor and I didn't make him pay a certain amount per month, he could have waited a year before paying me anything. All that time the interest would have been rolling and some would have compounded, so that he would start paying interest on interest on interest.

Now most financial institutions aren't as trusting as I was of Victor. After all, Victor and I go way back. And I don't trust all my friends that much. What if my friend Charlie wants me to lend him $1000?

Let's say I agree to lend Charlie $1000, but with the following stipulations. I'll charge him 2% interest per month (24% per year, because he's riskier than Victor), and additionally he needs to pay me $50 at the end of each month until his loan is repaid. So the first month I charge him $20 interest, he pays me $50, of which the remaining $30 is principal. Next month he owes $970, interest is $19.40; of his $50, $30.60 is principal, and at the beginning of the third month he owes me $939.40. And so on and so forth, Charlie keeps paying me the $50/month until his loan is gone after 26 months.

Notice how Charlie just paid the minimum. He could have paid additional money toward his principal and reduced his term duration and total interest paid, but he didn't. Even if he did I would have made him keep paying the $50/month, but he would have gotten out of his loan sooner. By the way, Charlie paid me a total of $289.87 in interest.

Okay I hope everyone is still with me so far. We got through the free-for-all case and the standard fixed-term loan case. Now for the advance-the-date case.

My third friend, Mike, is in between Charlie and Victor in terms of risk. So I make him a deal: same terms as Charlie, so that he has to pay me $50/month; except that if he pre-pays, I'll let him "advance the date". Every extra $50 he pays me will count towards that $50 I'm expecting at the end of each month. If one month he pays me an extra $500, I won't make him pay the $50 at the end of each month for ten more months. And I'll apply his payments first to interest, and then apply the remainder to principal.

Let's see what Mike does. First month is the same, his $1000 accrues $20 interest, he pays me $50 at the end of the month, $30 gets applied to principal, now he owes me $970. Next month interest is $19.40, but let's say he pays me $89.40 since he wants to shed this debt more quickly. $19.40 applies to interest, his principal is now $900, and I let Mike know he doesn't have to pay me his $50 at the end of the next month. Now, what happens at the end of the next month?

At the end of the next month, $18 interest accrues. Mike is trying to decide if he wants to pay the $50 — he doesn't have to, but maybe it would be best for him. So let's play out the example:

Say that Mike decides to pay up. He pays $50, $32 gets applied to principal, so now he owes $868. At the end of the next month $17.36 of interest will accrue. So that's $35.36 for the two months.

Now let's say Mike doesn't pay up. After all, he doesn't have to. He lets that first $18 interest recapitalize so now he owes me $918. By the end of the second month, the interest on that amount comes to $18.36. In total he's owing me $36.36 for the two months -- a full dollar more. Part of that extra dollar is interest from the recapitalized interest, and the other part is because he didn't pay down any principal during the second month.

What would you want to do if you were Mike?

Whew! Now let's talk about real loans


That example went on a little longer than I originally intended, but I think it illustrates exactly what's happening with the "advance the date" option. The DoE is giving people enough metaphorical rope to hang themselves with. When you advance the date, you're giving yourself flexibility. Maybe some emergency will come up and you'll be glad you don't have to make a payment this month. After all, you can still make payments even though you don't have to.

But, for me, the trade-off is always one between giving myself flexibility and creating commitment devices for doing what I know I should be doing. Is it nice that I don't have to make a payment on my big loan until February? Yeah, I guess. It also means I have less incentive to make sure I pay up on time. If I forget then interest will just silently accrue like a slow carbon monoxide leak, eventually suffocating me.

So my recommendation, for those of us who have an "advance the date" option on our loans, is to strike a balance between flexibility and forced commitment. Remember to make the minimum payment at least every month even if you don't technically need to. When you make an extra payment, advance the date only part of the time. As long as you're making your monthly payments it doesn't hurt you to advance the date, and you have a "just in case" ready if an emergency comes up and you need the cash. You'll still pay the loan off just as quickly. But beware of the temptation to slack on your minimum monthly payments, because with that only comes many more years of debt.

I hope that helps.