For first-time borrowers, student loans can seem complicated and daunting. Knowing that you’re using money now that you’ll have to pay off later can be stress-inducing, especially when the future is so uncertain. Read on to find the difference between principal and loan interest, what it is.
Many student loan borrowers sign up for loans optimistically and they’ve got it all planned out to a tee. From breaking down their expected salaries to allotting a percentage toward loan repayment, everything that’s needed to get rid of their debt faster. However, it doesn’t always go as smoothly. A study conducted by Cengage found that most student borrowers felt they would repay their loans within six years. In reality, it takes about 20 years on average to repay student loan debt.
What’s the reason behind this?
Understanding Loan Payment
Every loan payment you make in the way of your student loan has two components: loan principal and loan interest.
The former—loan principal—refers to the amount you actually borrowed, while the latter is the interest charged on that. When the time to start repaying your loan comes around, each amount is broken down into both component parts. The loan interest is often front-loaded in the payment and makes the larger chunk, the remainder that you pay over the interest amount is the principal payment.
Every payment you make, you pay down the original loan amount and are expected to pay lower interest in the next month. Ideally, this is the best way to repay your student loans since you’re making payments that reduce the principal amount instead of paying off interest that doesn’t make a dent in the loan’s original value.
The Bane Of Student Loans: Interest Payments
The process of repaying your student loans can be frustrating. You could spend years making monthly payments, only to realize the accrued interest has been eating up a chunk of those payments.
Paying interest on interest balance
This problem is exacerbated if you’ve opted for federal repayment plans like income-driven repayment or graduated repayment. In both cases, your monthly payments are controlled owing to your current financial circumstances. This might seem viable for someone who’s starting off their career, it means your monthly payments may be so low that you don’t even cover the interest. When this happens, the unpaid interest is capitalized—that is, it’s added to your loan balance. So, the next time you make a monthly loan payment, you end up paying interest on last month’s interest too!
Choosing the type of interest
The type of interest rate you select determines how your monthly payments are divided. Most private lenders allow you to choose between variable and fixed interest rates. The former tends to change owing to fluctuations in the index, but the latter stays fixed throughout the loan’s lifetime.
Interest payments stay the same when you opt for fixed interest rates and you can repay the loan smoothly if you stick with the repayment plan. However, variable interest rates provide better saving opportunities. As interest rates fall, people can take advantage of low monthly interest payments to make larger principal payments. The risk involved with variable interest rate payments can mean you end up accruing unpaid interest and facing capitalization.
Making smart debt-related choices
There’s no doubt that interest payments make loan repayment difficult, often causing financial duress and causing an extended repayment period. It’s imperative to remember that the quicker you pay off your loan, the more you can save.
Several federal and private lenders offer payment breaks to borrowers in times of financial difficulty. These can be in the form of deferment, forbearance, or grace periods. While it may seem like some much-needed relief from stressful loan payments, interest continues to accrue during this time.
Debt elimination relies on making the right decisions that reduce your monthly payments and save money spent on interest. Refinancing your loans and avoiding unnecessary deferment by prioritizing your loans are two strategic repayment choices you can make.
Focus On Principal Balance Repayment
The key to smooth, money-saving loan repayment is targeting your principal balance. The goal is to lower the principal amount to eliminate your debt and enjoy smaller interest payments over time.
Since student loans are amortized—that is, you pay down the debt by making contributions to the principal and loan interest —you need to find ways to strategically use this to your benefit. If you’re looking to knock down your principal balance, the following tricks may be useful:
Make extra payments each month
This effective debt elimination method requires you to create abudget and stick to it. When you make extra payments over the amount you owe every month, it offers a dual advantage.
Firstly, paying a little bit over the monthly payment amount ensures the additional money goes to your loan balance. This is especially effective with fixed rate loans since you can determine a set amount over the fixed monthly payment.
Secondly, when you start paying off the original loan value, your monthly installments will decrease in value too. Since interest is charged on the loan balance you’re paying toward every month, you’ll have to pay less interest too!
This means you can dedicate a larger percentage of money toward loan principal payments each month.
Avoid paying penalties
When you miss your loan’s deadline, your lender will expect a late fee that adds to their profit for the month. Since all the money received will go toward paying the penalties and interest, there’ll be little—if any—left for loan principal payments.
One way you can work around this is to make sure you avoid any undue penalties. Incurring any additional fees or foregoing deadlines will only result in longer repayment terms—and that’s something you don’t want.
Find a suitable lender
If you’re dedicated to paying off your loan early through targeted principal payments, it’s necessary to work with a lender who understands your goals. Some lenders may consider the extra monthly payments as a balance that reduces the next month’s payments, while others will automatically apply them to the principal.
Finding the right lender relies on several factors. Lower interest rates, a shorter repayment period, and favorable loan terms are all things you should look out for. Education Loan Finance’sflexible student loan terms and smart solutions to loan management will help you meet your financial goals.
A Final Word
Before you dive into student loans, it’s important to understand the process and how it affects your long-term goals. Speaking with financial advisors and private lenders will help you gauge the best loan terms for your needs.
About the Author
The writer is a young finance professional making their way through the world of student debt and understanding how to manage finances, tips, sharing advice, and expertise they have garnered through their experiences and interactions.