When you take out a student loan, you will not just be paying back the amount you borrowed – the lender will also charge you interest. The easiest way to think of interest is that it’s the cost paid by you to borrow money. Whether you take out a private student loan or a federal student loan, you will be charged interest on your loan until it is repaid in full. So, when you have finished paying off your loan, you will have paid back the original sum you borrowed (your original principal), plus you will have paid a percentage of the amount you owed (interest). Properly understanding the way that student loan interest affects your loan is imperative for you to be able to manage your debt effectively.
The Promissory Note
When a student loan is issued, the borrower agrees to the terms of the loan by signing a document called a promissory note. These terms include:
- Disbursement date: The date the funds are issued to you and interest begins to accrue.
- Amount borrowed: The total dollar amount borrowed on the loan.
- Interest rate: How much the loan will cost you.
- How interest accrues: Interest may be charged on a daily or monthly basis.
- First payment date: The date when you are expected to make your first loan payment.
- Payment schedule: When you are required to make payment and how many payments you have to make.
How Different Types of Student Loans are Affected by Interest Rates
Here’s an example: In your freshman year, you borrow $7,000 at 3.85%. By the time you graduate in four years, this will have grown to $8,078 – an increase of $1,078. Here’s the math: 7,000 × 0.0385 × 4 = $1,078 (Click here for ELFI’s handy accrued interest calculator.)
- Government-Subsidized loan: If you are the recipient of a government-subsidized direct loan, the government will pay your interest while you are in school. This means that your loan balance will not increase. After graduation, the interest becomes your responsibility.
- Parent PLUS Loan: There are no government-subsidized loans for parents, and regular repayments are scheduled to begin 60 days after the loan is disbursed.
- Unsubsidized Loan: The majority of students will have unsubsidized loans where interest is charged from day one. If you have this type of loan, sometimes a lender will not require you to make payments while you are still in school. However, the interest will accrue, and when you graduate you’ll find yourself with a loan balance higher than the one you started with. This is known as capitalization.
How is Student Loan Interest Calculated?
When you begin to make loan payments, the amount you pay is made up of the amount you borrowed (the principal) and interest payments. When you make a payment, interest is paid first. The remainder of your payment is applied to your principal balance and reduces it.
Let’s suppose you borrow $10,000 with a 7% annual interest rate and a 10-year term. Using ELFI’s helpful loan payment calculator, we can estimate your monthly payment at $116 and the interest you will pay over the life of the loan at $3,933. Here’s how to determine how much of your monthly payment of $116 is made up of interest.
1. Calculate your daily interest rate (also known as your interest rate factor). Divide your interest rate by 365 (the number of days in the year).
.07/365 = 0.00019, or 0.019%
2. Calculate the amount of interest your loan accrues each day. Multiply your outstanding loan balance by your daily interest rate.
$10,000 x 0.00019 = $1.90
3. Calculate your monthly interest payment. Multiply the dollar amount of your daily interest by the number of days since your last payment.
$1.90 x 30 = $57
How is Student Loan Interest Applied?
As you continue to make payments on your student loan, your principal and the amount of accrued interest will decrease. Lower interest charges means that a larger portion of your payments will be applied to your principal. Paying down the principal on a loan is known as amortization.
How Accrued Interest Impacts Your Student Loan Payments
The smart money approach is avoiding capitalized interest building up on your loan while you are in school. This is because choosing not to pay interest while in school means you will owe a lot more when you come out. The more you borrow, the longer you are in school, and the higher your interest rates are, the more profound the impact of capitalization will be.
How to Find the Best Student Loan
When looking for the best student loan, you naturally want the lowest interest rate available. With a lower interest rate, the same monthly payment pays down more of your loan principal and you will be out of debt more quickly. Talk to ELFI about our private student loan offerings by giving us a call today!
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When you start your post-college career, you may be tempted to breathe a sigh of relief. Before you do that, you have important decisions to make. You’ll have to stretch your paycheck to cover your new lifestyle and associated expenses: a furnished home or apartment, vehicle, insurance, and hopefully a 401K contribution
. If you are like 70% of college graduates, you also have student loans that need to be repaid.
In most situations, it's going to be most beneficial to pay off your loans as quickly as possible so that you are paying less towards interest. The average college graduate's starting salary
, however often cannot allow for enough additional income to cover more than the regularly scheduled student loan payments. Most student loans have a six-month grace period so you can do some budgeting and planning first - if you need to. We don't suggest using the grace period unless you find it necessary to organize your finances. During a deferment
such as a grace period, the interest could still be accruing depending on the type of loan that you have.
If you determine that you may be better off establishing sound financial footing and a workable monthly budget before you begin repaying those daunting loans. Keep these tips in mind as you formulate a strategy for debt payoff.
Student Loans Have Advantages
Varying types of debt are governed by different laws and regulations. Banks often base interest rates for consumer credit loans on your established credit rating. Interest rates for auto loans or credit card debt
tend to be higher than a mortgage or student loan interest. As you review your debt load and make a plan, remember: student loan debt comes with a few "advantages" that other types of debt don’t offer.
- Preferential tax treatment: With a new job, you will be paying taxes on your income. Student loan interest is deductible up to $2,500 and can be deducted from pre-tax income.
- Lower interest rates & perks: Federal student loans have lower interest rates and are sometimes subsidized by the government.
- Lender incentives: Private student loans may come with incentives from the lender that make them a better deal than other credit types. These include fee waivers, lower interest rates, and deferment options.
- Flexible payment plans: Options for lower payments and longer terms are available for both federal and private student debt.
- Build your credit score: You can build your credit score with student loan debt. Now, depending on whether you’re making on-time payments or not, you could negatively or positively affect your credit. If you chose to make small payments during deferments, or a grace period, and regular on-time payments you will be more likely to establish a favorable credit record and reduce the amount of interest you pay overall.
Programs to Help You With Student Loan Payments
There are few options for loan forgiveness with regular debt, but student loans offer opportunities to reduce or eliminate your debt. These may come with commitments and tax implications, so be sure you fully understand them if you decide to take advantage of these programs.
- Loan forgiveness: Federal student loans may be forgiven, but you'll want to be sure that you're following all of the requirements needed of the program. Be sure before choosing this option that the federal loans you have qualify for the program. Also, keep in mind there could be taxes due on the amount that is forgiven. Some student loan forgiveness programs include PAYE (Pay as You Earn) and REPAYE (Revised Pay as You Earn), Public Service Loan Forgiveness, and Teacher Loan Forgiveness.
- Loan Consolidation: Multiple student loans can be consolidated into one payment with the interest rate determined by a weighted average of your current loans - interest rates. Combining multiple loans may be easier to manage on a modest starting salary. Consolidating federal loans usually doesn’t require a good credit score, either.
- Refinance, and you could achieve a lower interest rate: Lenders like Education Loan Finance specialize in student loan refinancing, and have options like variable interest rates and flexible terms. Refinancing your debt could make student loan debt easier to manage than other types of credit.
Pay Off High-Interest Debt First
Before you decide to pay off your student loans, think about the financial obligations you’ll be taking on. Instead of carrying a credit card balance or making low payments for an auto loan, it makes sense to continue your low student loan payments and pay off more expensive debt first or debt with a higher interest rate
. In the long run, you’ll save money and build your credit score.
If you still have doubts about not paying off student debt first, consult a professional financial advisor for help prioritizing your goals and setting up a budget that lets you achieve them.