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How Making Interest Payments Can Save You Big Money Later

If you're funding part of your college education with student loans, you may occasionally receive statements, even though no payments are due. Ever wonder why?

Those statements are important, and understanding why can save you money in the long run.

They notify you that, even though you don't have to make payments while you're in school, interest is adding up on your loans — every single day. If this interest is not paid as it accrues or before your loans enter repayment (usually six months after you leave school), it will be added to your principal balance. If it is added to your principal balance (a process called capitalization), you will then owe more than you originally borrowed. And, the now larger principal balance starts to accrue interest on a daily basis, so you will be paying interest on the accrued interest.

How can you minimize this increase to your loan balance?

If you manage to earn or save some money while you're in school, you can make monthly payments that pay down the interest as it accrues.

Here's an example of how making small payments every month could save you more than $1,500 over the full life of student loans.

Note: The information below is an example only. Your payment amounts will depend on the types of loans you receive and the interest rates and the repayment terms on those loans.

How interest payments can save you money

Saving Money In School: Interest is adding up on your loans — every single day. With a total amount borrowed of $29,000, in this example, monthly interest is $22 in year 1, $44 in year 2, $66 in year 3 and $88 in year 4. If none of that interest is paid in college, it is all added to the loan when repayment begins, for a principal balance of $31,876 at repayment. The original balance increased because of capitalization. If the monthly interest is paid in college, however, $2,876 would be paid before repayment begins. The principal balance at repayment would be $29,000; paying the interest while in school kept the original balance the same.

Saving Money in Repayment: With the higher principal balance of $31,876, the interest paid during repayment is $13,845, for a total paid over the loan term of $45,721. With interest paid during school and a principal balance at the original $29,000, $12,163 in interest is paid during repayment for a total amount paid over the loan term of $44,039. Paying the monthly interest as it accrued while in school results in $1,681 in interest savings over the life of the loan.

Assumptions:

  • Borrower is in school for four years.
  • Student borrowers a total of $29,000 ($7,250 for each of four years).
  • Total of $23,000 is in federal student loans with 50% of the loans subsidized and 50% unsubsidized.
  • A fixed interest rate of 5.05% and a 10-year repayment period for federal student loans.
  • The remainder of the debt in private student loans.
  • A fixed interest rate of 7.75% and a 20-year repayment term for private student loans.
  • Interest payments start in September each year and continue through six month of grace (51 months for year 1 loans and 39 months for year 2 loans, 27 months for year 3 loans and 15 months for year 4 loans.
  • 360 days per year.
  • 30 days per month.
  • In-school interest accrual begins at loan origination, capitalizing once at the beginning of repayment.
  • Origination fees are not factored into the example.

Establishing Financial Habits

Making everyday spending decisions—like whether to order pizza or go to the Caribbean for Spring Break—in college, helps you establish the financial habits you'll use in the future.

Although eating out every Friday night sounds like a good thing, it may be worth it to give up that treat in exchange for savings of thousands on your future student loan payments.


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