Why did my whole payment go to principal?

With the holiday we are taking the day off. But here is one of my favorite posts about a topic no one understands, borrower cancellation payments. Enjoy while eating a burger!

Borrower cancellation payments occur when you make a payment within 120 days of any disbursement.  Instead of the money being applied to your interest first and principal second like a normal payment, this money goes straight to your principal and cancels out your interest.  Loan companies deal with many calls from confused borrowers who feel like instead of their interest being cancelled it just simply isn’t getting paid the way they want it to.  In many cases this leads them to request to have their loan payment reapplied to being a regular payment even though the cancellation payment is more beneficial.   While this is not something we have the luxury of doing over the phone, here is an example to demonstrate the power of borrower cancellation payments:

A borrower has an original balance of $5,000.00 and an interest rate of 6.8%.  The borrower makes a $2,000.00 payment 90 days after disbursement (which is within the 120 day cancellation window).  For this example we will assume this is the first payment on the loan the borrower has made.  Here is how the payment is applied as a regular vs cancellation payment.

To calculate we must know how interest accrual works.  Remember interest is figured by taking principal x int rate/365.  In this example that is $5,000 x .068/365=$.93/day.  Since this is the first payment made and 90 days of interest has accrued we multiply the daily interest amount by the number of days—> $.93 x 90=$83.70.

When a regular borrower payment is made, interest is satisfied first with the rest going to principal.  So the $83.70 goes to interest and $1,916.30 to principal.  This reduces the borrower’s principal balance to $3,083.70.

However if the payment is a cancellation payment, it goes straight to principal and cancels recalculates the interest.  So the same $2,000 payment does the following.  $5,000 (original balance)-$2,000 (borrower cancellation payment)=$3,000 (new principal balance interest is calculated off of).  If you figure out 90 days of interest on $3,000 the equation looks like this:

$3,000 x .068/365=$.56/day; when you multiple $.56/day x90 days of interest=$50.40.  You add your new principal plus the interest accrual together to get your new balance of $3,050.40.

As a result your payment of $2,000 was really like making a payment of $2,033.30 because of the cancelled interest.

This is really one of the coolest programs out there that no one understands.  Do the student loan world a favor and show your friends!