Have you ever looked at a statement for your student loans and been completely shocked by how much money is going towards interest?
A reader wrote in to Ask Carly to find out how student loan interest rates work.
Ask Carly is a way for us to stay connected and support one another on our journey to gaining financial independence. It’s a judgement-free place to get some solid advice, because you don’t need to figure this money stuff out on your own.
How do interest rates work? I realized I owe around $70,000 in student loans, but my money is going to interest more than my loans!?? What is going on?
It’s incredibly easy to sign FASFA papers as a teenager to borrow thousands of dollars but understanding how interest works is much harder.
If you look closely at the interest on your student loan, or even for your mortgage, you’ll likely also have an “OMG!” moment. Your payment is the same each month, but the majority of it goes to interest, especially within the first few years.
How Student Loan Interest Works: Your Repayment Terms
First to understand interest, it’s important to know what type of loan repayment you have. Here’s a run-down of four main repayment plans.
- Standard Repayment- pay less overall in interest with a fixed interest rate, and ten-year repayment.
- Graduated Repayment- you’ll pay lower per month towards your debt initially, but your payment will increase about every two years and the loan will be paid off within 10 years.
- Extended Repayment- For borrowers who owe over $30,000 repayment is stretched over 25 years.
- Income Driven– this can be called income based, pay as you earn, revised pay as you earn, or income contingent. The monthly payment is capped at a percentage of your discretionary income (10-20%) and paid over 20-25 years.
Other Student Loan Terms to Know:
- Subsidized Loans- the U.S. Department of Education pays interest on the loan while you are enrolled at least half time, for the first six months after you finish school, or during a period of deferment.
- Unsubsidized Loans- you’re required to pay interest on the loan while in school, after graduation, and if any payments are missed the interest is added to the principal or amount owed.
- Deferment- a postponement of payment during school, six months following graduation, economic hardship (unemployment), or military service.
- Forbearance- if you can’t make your payments, but don’t qualify for deferment. Interest accrues on subsidized and unsubsidized loans.
With Student Loan Interest Time is Money
Your student loan interest is a fixed, or set amount, depending on the lender. The shorter the term, or number of years to pay off your loans, the less you’ll spend in interest.
For example, let’s look at someone with the average student loan debt of $37,172 with interest rate of 4.66% paid out over ten years versus twenty-five years.
With a ten-year repayment the monthly payment is $388.12 and $9,400.12 will be spent in interest over the life of the loan.
With a twenty-five-year repayment the monthly payment would be $210, but $25,829.30 will be paid in interest over the life of the loan.
As the example shows, time really is money when it comes to paying off loans.
Understand Simple Interest Versus Compound
When it comes to interest, most often people think in terms of simple interest versus compound interest. For an easy example, let’s say you owe $10,000 and have 10% interest.
You’d spend $1,000 in interest, or $10,000 X.1. Compound interest on the other hand, is when your interest accrues on what it owed and on interest. Essentially you pay interest on your interest.
Understanding Amortization and Student Loan Interest
Most all student loans are calculated with interest that compounds daily. To see how much of each payment goes towards interest versus your principal you can view an amortization schedule like this one.
Student loans are amortized, or in other words the debt is paid off with a fixed interest rate, payment, and set number of months. In the beginning of the repayment the majority of what is paid goes towards the interest, and not the principal.
With each payment a greater portion of the payment will go towards the principal. For example, a $10,000 loan, with 10% interest paid off over 10-years will have a monthly payment of $132.15. The first payment $83.33 will go towards interest and $48.82 towards principal. The next payment $82.93 will go towards interest and $49.22 will go towards the principle. Over the life of the loan $5,858 will go towards interest.
It’s crazy how compound interest works: $5,858 will be paid on interest for a $10,000 loan.
Tips for Paying off Student Loans
Here are some quick tips for paying off your student loans and reducing how much you spend in interest.
- Automate your monthly payment so you never miss a payment
- Don’t ever ignore your loans- the interest accrues, and you’ll end up owing more
- You’ll save thousands in interest by having a shorter 10-year repayment
- Pay a set amount extra to be applied to your highest interest student loan’s principal
- Increase your income and/or cut your expenses to pay extra monthly
- Don’t do it alone! Surround yourself with friends who are also on a mission to get out of debt
Here are more posts on how to get out of debt:
- 8 Copy-Worthy Habits of Debt-Free People
- Should You Stop Investing for Retirement Until You’re Debt-Free?
- What if you Can’t Pay the Monthly Payments on your Debt?
Here are real people who’ve made real progress paying off debt:
- How Kim paid off $45,404 in Debt in 28 Months
- How Jennifer Paid Her Grad School Loans Off Six Years Early
- How Jessica and Daniel Paid off $21,000
That is how student loan interest works. Get started paying off your student loans now and save thousands of dollars in interest. Here’s The Ultimate Guide to Managing Money, a free downloadable guide with more brilliant tips on how to get out of debt.