Student loans are different than car loans and mortgages because the majority of student loans allow you to defer repayment while you're attending school on at least a half-time basis. While this is a convenience if you are unable to make payments while attending classes, it also means that you could end up paying much more. Unpaid interest can capitalize (be added to) your principal balance and can significantly increase your loan balance from the time you take out a loan until you begin repayment.
For example, a $5,000 loan with a 6.00% interest rate accrues $300 in interest in one year. That may not seem like much, but if you take out that $5,000 loan your freshman year, do not take out any other loans and do not make interest payments while you're in school, that $5,000 loan can increase to a principal balance of more than $6,300 in four years because interest accrues over all four years while you are in school.
How Interest Is Calculated
Student loans accrue interest daily on a simple interest formula:
Principal balance x interest rate / number of days in this year = daily outstanding interest
Using the example above, when the loans enter repayment with a balance of $6,300 with 6.00% fixed interest during a non leap year, the daily interest would be calculated as:
$6,300 x 0.06 / 365 = $1.0356
You would accrue $1.0356 in interest every day as long as your principal balance is $6,300. If there were 30 days from your last payment and all previous outstanding interest was paid with your last payment, the monthly interest in this example would be $31.07.
Capitalization During Repayment
The example loan already had interest capitalized once after college. Did you notice what happened then? Interest began accruing on the new, higher balance, so essentially the capitalized interest is also now accruing interest.
The same thing can happen when a loan is in repayment. Many loan servicers and lenders allow borrowers to temporarily delay required payments during certain circumstances, such as a period of unemployment or financial hardship. At the end of that assistance period, any unpaid accrued interest would be capitalized, further increasing the loan balance, which then begins accruing more interest.
How Interest Is Paid
You can pay down interest by making regular monthly payments, even before you enter repayment, to reduce the impact of interest capitalization and the total amount to be repaid.
Your loan term calculates the paying of interest throughout the life of the loan. Any payments you make go first toward any interest that has accrued since your last payment. So, if you pay late or skip payments, more of the next payment goes toward interest that has accrued in the meantime, and less (or even none) of the payment goes toward the principal balance.
Even if you are using assistance to delay regular payments or payments are not required while you’re in school, you can make payments to cover the accruing interest to avoid capitalization.
Other Ways to Reduce Loan Costs
One of the best ways to lower the amount of debt you need to repay is to minimize the amount of loans you take out or try to avoid student loans completely. Check out cost-saving tips and free online resources like Student Loan Game Plan to get started.
Once you have student loans, make a plan for repaying them successfully. You may also wish to consider refinancing to achieve better loan terms, either while you are still in school or after your loans have entered repayment.