Did you know that more than half of all American students will take out a student loan in order to complete their degree?³ It’s true! And with student loans being such a common way to finance an education, it can be helpful to know what you’re signing yourself up for before taking out a student loan.
The information we are outlining today will help you understand how student loans work, how much your student loan will actually cost, and how making extra payments will impact your loan.
Let’s begin by reviewing one of the final steps you’ll take before receiving student loan money — signing a promissory note. A promissory note is an important document that explains all of the terms of the loan. A few key pieces of information in this document that you’ll need to review before signing include:
- Disbursement date. This is when you will receive the funds and when the interest will start accruing on the loan.
- Amount borrowed. This is also known as the student loan principal. We will cover more about the principal below.
- Interest rate. This is the amount you have to pay in order to borrow the money.
- How interest accrues. This part of the document will tell you how the interest on the loan will accumulate over time. Typically student loan interest accrues daily or monthly.
- How interest capitalizes. This is a fancy way of talking about when the accrued interest will be added to your principal balance. This is important to note because once the accrued interest is added to your balance, interest will start accruing on the new amount. Think of it as interest growing on interest.
- First payment date. This is when you need to make the first loan payment.
- Payment schedule. This part of the promissory note will tell you how many payments you have to make to repay the principal and interest of the loan. Included in the section will be how much your monthly payment will be.
Now that we have walked through some of the important information included in the promissory note, let’s learn more about three important issues related to a student loan:
- What is a student loan principal?
- What is student loan interest?
- How will additional payments made on your student loan affect the principal and interest?
What is a student loan principal?
The principal of your student loan is the total amount of money you borrowed to pay for your education. For example: if you borrowed $28,500, then the principal of your loan will be $28,500.
There are several important factors to consider before taking out a student loan, one of which is how much student loan debt will be manageable for you after you graduate. For more information on how to estimate this number, read our 4 Tips Before Taking Out a Student Loan blog post.
What is student loan interest?
Unfortunately, student loans are not free. Not only do you need to repay the principal amount, you need to repay the student loan interest. Student loan interest is the amount you have to pay to borrow the principal amount. There are different types of student loan interest. Keep in mind that the interest on the loan is determined by the loan type and lender
A student loan interest rate is either a:
- Fixed interest rate. This rate is set at the time you accept the loan and this rate won’t change over the life of the loan. There aren’t too many surprises on fixed interest rate loans. The interest never changes, and your repayment plan will be very consistent. The way you can change the interest rate of your student loan is by refinancing the loan to an, ideally, lower interest rate.
- Variable interest rate. Variable rates will fluctuate over the life of the loan based on market rates. What do we mean by this? Depending on your loan servicer, the interest on the student loan will be tied to an index rate like LIBOR (the London Interbank Offered Rate) or prime rate, to name a few. While the starting interest rate may be lower when compared to a fixed interest rate, be prepared to have the rate and monthly payment change over the life of the loan. Sometimes it goes up, and other times it goes down. It all depends on the index rate the loan is tied to. Side note: Federal Student Loans do not include variable interest rates.
Now that we’ve talked about the type of interest a student loan can have, let’s talk about how student loans accrue interest. Student loans accrue interest over time. This means you will have to pay more than what you initially borrowed (the principal amount).
While you may be able to defer interest payments on some types of loans while you are in school or starting your career, the loan interest may still accrue during those times.
One exception is subsidized student loans. For these types of loans, the federal government pays the interest on the loan while you are in school, and you do not need to repay the government for the payments they make for you during this time. You do have to demonstrate a need for financial assistance to qualify for a subsidized student loan. To see if you qualify, you need to complete and submit a FAFSA form. For the latest information on deadlines for FAFSA forms visit StudentAid.gov. For these loans, once you graduate you will take over paying the interest on the loan.
To gain a better understanding of the impact of interest on student loans, let’s consider this example. From your promissory note, you gathered the following information about your unsubsidized student loan:
- Loan principal: $28,500
- Fixed interest rate: 4.66%
- Loan term (length of the loan): 10 years
- Monthly payment: $298
Based on these numbers, and the assumption that you will only make the minimum monthly payment over 10 years, the total lifetime cost of your student loan will be $35,709. This means the total amount of interest you will pay is $7,209. The good news is you can decrease the total amount of interest you will need to pay by making additional monthly payments on your student loan. Even adding $5 or $10 to your monthly payment can make a difference in the total amount of interest you will pay over the life of the loan.
How will additional payments made on your student loan affect the principal and interest?
Like we stated above, it is important to pay off both the interest and principal of your student loan. Once you enter into the repayment period, you will be required to make monthly payments on your loan. Monthly payments cover fees on the loan (e.g. late fees), monthly interest on your loan, and part of your loan’s principal amount.
Each student loan servicer has a different approach when applying your monthly payment to your loan. Before entering into your repayment period, see if you can answer the following questions about your loan:
- How much of the total monthly payment is being applied to the interest?
- How much of the total monthly payment is being applied to the principal?
- Are there any loan fees you need to pay off or are currently accruing?
If you cannot answer these questions by looking at your promissory note, or by logging on to the customer portal for your loan, contact your student loan servicer.
Once you’re able to answer these questions you’ll be able to start crafting your own repayment strategy. The quickest way to pay off your student loan is to make additional payments to the principal of the loan. The smaller the principal amount of your loan, the smaller the amount of interest that will accrue, making it faster to pay off the loan.
It’s important that you take into consideration how an extra payment on your loan will affect your overall monthly budget. If you do not have a budget, a good starting place is using the 50/30/20 strategy. You can use the information from your budget to help you avoid a situation where if you make an additional payment you would be unable to pay other bills or living expenses.
If you can make additional payments on your loan, it is crucial to take the time to see how your student loan servicer will apply the additional payment. Often student loan servicers will view an additional payment as a “paid ahead” amount for future payments. As uncool as that sounds, it’s the unfortunate truth. For example, if your student loan payment is $298 per month and you make an additional payment of $100, your next monthly payment will be $198 if it’s deemed to be “paid ahead.”
To change this, you need to contact your student loan servicer to make sure your additional payment is applied to the principal of the loan. After receiving confirmation that they will apply your additional payment in this way, you still need to carefully examine your student loan statements. Do this to ensure your student loan servicer is actually following your request. This may sound over-the-top and time-consuming, but getting this right may save you a lot of money and headaches down the road.
If you’re currently still in school, another possibility to consider to help decrease the principal amount of your loan before you enter into the repayment period is making payments while you are in school. Again, any amount that you’re able to pay towards the principal of the loan before interest begins accruing, or before you enter into the repayment period, will help you decrease the total amount of interest you need to pay.
The bottom line . . .
Understanding the basics of how student loans work will help you figure out how much student loan debt you can realistically handle after graduation. If you are able to afford to make more than the minimum monthly payment when you enter a loan’s repayment period, consider if this is something worth doing. By applying the additional payment to the principal of the loan you’ll be able to decrease the total amount of interest you will pay and be a few steps closer to financial freedom.