Written by Kristyn Pilgrim

Understanding Student Repayment Interest (Calculations Behind It)

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    Understanding Student Repayment Interest (Calculations Behind It)

    Written by Kristyn Pilgrim

    If you’re new to the world of student loans or have always felt like the math behind it all was always sort of nebulous, then read on. 

    First, realize that you are not alone. Many people find it confusing. Just like with taxes, there’s a reason a lot of people have jobs that are designed to help you figure this all out. 

    But knowledge is power, and hopefully, with what is provided in this article, you will feel a little more empowered in your understanding of how your student loans work. And with that, you can move forward, making confident, informed decisions about your finances.

    Student Loan Interest Basics

    The first thing to understand is what interest is and how it works. When you get a student loan, you are told it comes with an interest rate. Perhaps something like 4.53%. You know that this makes the amount that you owe grow in some way, but how?

    That percentage is the annual rate. This means that if no payments are made in a year, the amount of money you owe will increase by 4.53%. How the math works out is as follows:

    • 4.53% as a decimal is 0.0453 (which is what you get if you divide 4.53 by 100. The word “percentage” means “per hundred”).
    • Multiply this decimal by the principal loan balance (the total amount you owe), and this will give you the amount of accumulated interest.
    • For example, if you begin the year with $10,000 in debt and make no payments, then you will owe an additional $453 in interest (0.0453 x 10,000).

    But often, when a loan is gaining interest, you are also making regular payments, and those happen monthly, not yearly. So, how does that work? Well, each month, your loan balance gains one-twelfth the interest it would in a year. If you take the annual interest rate and divide it by 12, this is the monthly interest rate.

    A 4.53% annual interest rate becomes a 0.3775% monthly interest rate (4.53/12). After one month, then, a $10,000 balance would gain 0.003775 x 10,000 = $37.75. When you make the monthly payment on your loan that month, the first part of the payment will cover the interest, and the rest will lower the principal. 

    Because the principal is usually lowered with each monthly payment, the amount of interest owed the following month will be slightly less. And because of this, over time, a greater portion of your payment goes to the principal than it does to the interest. 

    To illustrate this, consider what happens after that $10,000 has been paid down to $5,000. The amount of interest it gains in a single month at the same interest rate as before is only $18.88. 

    Note that while federal student loans have fixed interest rates (the interest rate stays the same the entire time you are in repayment), some private loans have variable interest rates. This means that those rates change over time, often monthly, quarterly, or annually. Because of this, your monthly payment amounts are likely to change, as well.

    Compound Interest and Capitalization

    Another thing that can occur with interest is capitalization. This happens when unpaid interest gets added to your principal loan balance. That interest then begins to compound, meaning it gains interest itself. 

    In most cases, interest doesn’t capitalize when you make monthly payments on a loan because you pay off the interest each month. But there are situations in which capitalization does occur. With federal student loans, if the loan gains interest during a time of deferment (such as while you are in school) or forbearance, interest will often capitalize at the end of that period and before repayment begins.

    For some income-driven repayment plans, your required monthly payment might be low enough not to cover the accrued interest each month. When this occurs, however, the government covers the difference so that there is no capitalization. (Interest may capitalize, however, if you fail to certify your income or choose to leave one of these repayment plans voluntarily.)

    Interest capitalization on private loans depends on the terms given by the lender. Unpaid interest may capitalize monthly while you are in school if you are not required to make payments during that time or capitalize at once when you enter repayment. Contact your loan servicer for details about your specific private loans.

    Interest on Loans While in School, Deferment, or Forbearance

    When it comes to federal student loans, there are certain loans and times when loans may not accrue any interest and other times when they do. It’s important to be aware of all of these details so that you can plan accordingly. Federal student loans fall into two main categories: subsidized and unsubsidized. 

    For subsidized student loans, the government pays the interest on those loans while you are in school and for a six-month grace period after you leave school. The government will also pay interest during any other deferment period, but not during a period of forbearance.

    Unsubsidized student loans begin to accrue interest immediately upon disbursement and accrue interest during deferment and forbearance periods. Any interest that is not paid during those periods will capitalize when repayment begins.

    One exception to this results from the Coronavirus Aid, Relief, and Economic Security (CARES) Act. Between March 13 and Sept. 20, 2020, no interest on any federal student loans will accrue or be capitalized. In addition, no payment is required during this period.

    Total Interest Paid on Different Repayment Plans

    As a general rule, the quicker you pay off a loan, the less you pay in total interest during the lifetime of that loan. For example, compare repayment under the Standard Repayment Plan (10 years) with the Extended Repayment Plan (25 years) for a loan balance of $30,000 at 5%.

    Under the 10-year plan:

    • Monthly payments are $318.20.
    • The total paid at the end of 10 years is $38,183.59.
    • The total interest paid is $8,183.59.

    Under the 25-year plan:

    • Monthly payments are $175.38.
    • The total paid at the end of 25 years is $52,613.10.
    • The total interest paid is $22,613.10.

    So, while the 25-year plan offers lower monthly payments, in the end, you end up paying over $14,000 more in total. 

    The Graduated Repayment Plan allows you to start with lower payments that increase over time, paying off the loan in the same 10 years as the Standard Plan. However, you end up paying more in interest, as well, because of the lower payments made in the beginning, which allow the large balance to accrue interest for longer.

    There are several income-driven repayment plans. It’s more difficult to determine what you will pay in total interest since the monthly payments change each year, depending on your income. These plans are often appealing because you know that your payments will be lowered if your income lowers. Many of these plans also offer loan forgiveness after making a certain number of payments (usually 20 or 25 years worth of monthly payments). 

    However, most people will end up paying off the entire balance before reaching the forgiveness mark. And because payment is usually extended over a longer period, they also often pay more interest.

    How Loan Consolidation and Refinancing Affects Total Interest Paid

    When you consolidate your loans, you basically take all of them and roll them into a single loan. The interest rate on this new loan will be a weighted average of the interest rates of your individual loans if done through the federal student loan program.

    What does this do? Well, before consolidation, you had the option of paying more than your minimum payment each month and asking that the extra go toward the higher interest loans. This could end up saving you more in interest during the lifetime of the loan. 

    If you didn’t have any plans to pay extra, then consolidation likely makes no difference to your payment terms. It can do, though, make you eligible for repayment options that you may not have been eligible for before.

    Refinancing usually involves changing lenders. The new lender pays off the old lender, and you now pay your remaining loan balance to the new lender. When you do this, the terms of your loan can change. People often choose to refinance to get a lower interest rate. But note that when you refinance, even if the interest rate is lower, if the payment term (time to pay off the loan) becomes longer, then you could still end up paying more in the end. 

    Find a good loan calculator online if you want to compare terms and rates on your loan balance to determine the best financial option for your situation. 

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