Student Loan Basics
We know that obtaining, refinancing or consolidating student loans can be a daunting and stressful experience. We want to help with this process and arm you with information that allows you to make informed decisions that work best for you both short and long term. In this article, we'll focus on the basics to get you started.
Monthly payments & Interest Rates
Knowing the importance of interest rates compared to monthly payments can help guide you in deciding on the loan for yourself.
In most (but not all) cases, It turns out that the interest rate is usually much more important than the monthly payments. That’s because most people care about the total repayment amount the most. How do you know how much the loan will cost you, overall, in the long-term? What you can keep in mind is that the higher the interest rate, the higher the total cost of the loan. This is why a lower monthly payment doesn’t necessarily mean a lower total repayment.
Why is that? Well, let’s say you were making monthly payments of $100 for 5 years. I could offer you a “better” loan with monthly payments of $90. But, if the interest on the “better” loan had 1% higher interest, you’d end up paying almost $3,000 more over the lifetime of the loan. (With the higher interest, it would take you 5 years longer to pay it off.) Here is a chart that shows what this scenario would look like.
Does the monthly payment not matter at all? No, the monthly payments definitely matter in many cases. If the minimum is too high, and you can’t pay it, it’s not a good loan for you. You want a loan that has the lowest possible interest rate AND a minimum monthly payment that you can meet.
Here is another scenario to help with understanding the impact interest rates can have.
Let’s say you have a 5-year loan of $1,000, with 5% interest. 5% of $1,000 is $50, so you might think, “I need to pay an extra $50 in interest per year.” Unfortunately, it's not that simple since the interest on loans compounds. That means, not only do you need to pay interest on the principal (the amount of the loan--in this case, $1,000) but you also need to pay interest on the interest.
What that means is that after the first year, you owe your principal of $1,000 plus the first year’s interest of $50. After the second year, you owe 5% interest on $1,050, not $1,000--that’s $52.50. (You’re paying interest on the interest, which is where the extra $2.50 comes from.) At the end of the third year, you’d owe interest on $1,102.50, which is $55.13--and so on. Overall, you’d have to pay $1,276 for the $1,000 loan.
Because of compounding, interest grows exponentially. This may not seem fair, but you’ve also earned compound interest, so it has the ability to benefit you as well, such as when you use a savings account. You can also take advantage of compound interest by investing in the stock market. The good news is that our interest usually doesn’t add up that fast, since you’re paying off the loan a little at a time. Let’s say each year you pay off $231 on the loan. So in the second year, you’re only paying interest on $819, not the full $1,050, which means that after 5 years you’ve paid it off--and you’ve paid a total of $1,155. This is why the bigger of a payment you can make, the less you pay in total--since less interest accrues.
Keep in mind that most student loans use amortization. This means that interest is charged monthly, and payments first apply to interest and then principal. This is helpful to note, so you understand where you payments are going, how they are distributed and the impact of making payments prior to the monthly due date. If you are able to make a payment early, even by just a day or two, it reduces the interest you pay over the life of the loan because the interest is calculated based on the day the payment is made.
Because of how amortization works, larger payments put more toward lowering the principal, which lowers your interest cost every month going forward. Bottom line; the faster you pay off your loans, the more you save on interest costs. We have several tools that can facilitate this as well.
- The most important number for a loan is the total repayment amount because this is how much the loan will cost you long-term.
- The interest rate has the biggest impact on total payoff. Compounding (paying interest on the interest), often causes rates to be higher than they appear. i.e., a 12% APR is really 12.7% interest annually.
- When picking a loan, go for the lowest possible interest rate given a minimum monthly payment that you can meet. Keep in mind that amortization is key with student loans.
- If you already have a loan, you still have options. You can compare new loans, and often consolidate different loans into one place through refinancing.