When you take out a loan, it is important to understand how the terms of that loan affect your total loan balance. Your total loan balance is the sum of all the money you borrowed plus any interest and fees that have accrued since taking out the loan. Here are some ways that your federal student loans can affect your total loan balance:
What increases your total loan balance?
Interest is a percentage of the amount you borrowed to pay for school. Interest is calculated each month on your total loan balance, including interest that has accrued. The rate of interest (the percent) will be determined by your financial situation and other factors such as credit history, income and assets.
Interest from student loans
Interest is a percentage of the amount you borrowed to pay for school, which may include:
- the principal balance (the amount owed at the time you borrow, excluding any fees and origination points)
- any capitalized interest that has been added to your loan principal balance during deferment or forbearance (a period when you temporarily do not have to make payments)
Interest is calculated on a daily basis. For example, if you take out a 10-year loan and make monthly payments, more than half of your monthly payment will go toward interest rather than principal. If your repayment term is shorter than 10 years, then even more of each payment will go toward interest.
How is simple interest calculated?
Simple interest is calculated on the principal balance at the end of each month. The creditor doesn't make a new calculation every time you make a payment, so it can be difficult to understand exactly how much interest has been added to your outstanding balance. Let's take a look at an example:
- You borrow $1,000 for one year at 10% simple interest and make monthly payments (see below).
- At the end of each month, you pay $100 toward reducing your debt. The amount you owe goes down by $100 even though only 1/12th of that payment went toward paying off any principal owed.
How is compound interest calculated?
Fact: Interest is calculated on your total loan balance, including interest that has accrued.
This means that when you're calculating your monthly payment, you'll want to keep an eye on how much money was added to your principal balance since the last time you made a payment. If you've been making payments regularly and consistently, then it's likely that the amount of money being added to your principal balance each month is lower than it otherwise would be if those payments weren't being made. This will help ensure that over time, more of each payment goes toward paying off the principal than toward paying back interest.
How does capitalization occur?
Capitalization occurs when you make only the minimum monthly payment and allows lenders to add unpaid interest to your principal balance. This can increase your total loan balance. For example, if you have a $300k mortgage with 20% down, a 7 year term and 4% APR (with no other fees) and make only the minimum payment each month ($1,052 in this case), after 20 years of capitalization would be roughly 80% paid off!
To avoid capitalization:
- Make larger payments than those required by your lender’s payment schedule.
What factors increase total loan payment?
Income-Driven Repayment (IDR) and Extended Repayment are programs available to borrowers who need to make lower monthly payments than what they would be required to pay under the standard repayment plan.
Income-Driven Repayment plans work by applying a portion of your total eligible federal student loan balance toward interest, while extending the term of repayment. The remaining portion is then applied toward principal.
With IDR, any payments made under other plans will be recalculated according to the new payment schedule that is appropriate for you based on your income and family size. You may also qualify if you have high debt relative to income or meet other conditions such as having a partial financial hardship or being unemployed and looking for work.
What effects total loan balance?
The total loan balance is the amount you owe on your federal student loans. It's the sum of all monthly payments, all interest paid, and all capitalized interest (interest that has been added to your principal balance). If you have more than one federal student loan, you'll also want to keep track of each individual loan's total loan balance separately; this is especially important when dealing with consolidation loans and other programs that combine multiple federal student loans into a single new one.
Understanding what can affect your total loan balance is important so you can make the best decisions possible when paying back your federal student loans.
By understanding the different ways that your total loan balance can increase and how it affects your repayment process, you will be better equipped to make informed decisions about managing your student loans.