how interest works
Before getting a loan from a bank, a credit union, or some other lender, you must make an “interest agreement" with the lender. Through these agreements, you promise to pay back:
- the principal balance — the original amount you borrowed
- the interest — a fee that you pay the lender in exchange for borrowing the lender’s money
- Interest is calculated as an annual percentage rate of the amount you borrowed.
- For example, if you borrow $100 at 6.8% interest, at the end of the year, the interest you’ll owe on your loan will be $6.80.
- In this example, your estimated daily interest is around 2 cents per day ($6.80 divided by 365 days in a year).
Education loans accrue (accumulate) interest charges on a daily basis. With daily interest, you accrue one day’s worth of interest for each day you owe a balance to the lender. The higher your principal balance is, the greater your daily interest charge will be. The lower your principal balance is, the lower your daily interest charge will be.
Let's look at one of the most common loans that students use --- the unsubsidized Stafford loan. Here’s what your payments will look like if you repay your loan over 10 years with minimum monthly payments:
- You have a principal balance of $10,000 in unsubsidized Stafford loans.
- Your interest rate is 6.8%.
- Your payment will be about $115 each month (120 payments made over 10 years)
- Over 10 years, you’ll repay approximately $13,763:
- $10,000 of original principal
- $3,763 in interest
Try not to:
- make late payments.
- You’ll pay more interest because you’re paying down your balance more slowly than was expected.
- defer interest payments.
- If you take out an unsubsidized loan, you’re responsible for the interest that accrues even while you’re in school.
- If you decide to defer (delay) paying the interest, be aware that your lender may “capitalize" your interest at the end of your deferment. “Capitalized interest" means that the accumulated interest is added to the principal of the loan.
- Basically, capitalized interest causes your principal balance to grow and increases the cost of repaying your debt. A larger principal balance means you’ll pay more interest over the life of the loan.
- Example: You borrow $10,000 in an unsubsidized loan at 6.8% interest rate.
- If you make no payments until your loan enters repayment in two years, then approximately $1,360 of your accrued interest will “capitalize" (be added to your principal). As a result, your principal balance will become $11,360, and your overall interest charges will increase.
- Depending on how much you borrow (and the amount of time, if any, during which you defer your interest payments), capitalized interest could cost you a substantial amount.
- go into “default."
- Default happens when a loan is not paid back as promised and it goes significantly past due (according to the terms and conditions of the promissory note). Upon default, loans are filed with a guaranty agency, a collection agency, or the federal government for collection.
- The agency that now has your defaulted loan will add a default fee to your loan. This is a federal regulation. The fee is a percentage of the principal and interest that remain on your loan. Default is very expensive because now you have to pay back your principal, interest, and additional default penalties.
- At the time of default, the loan balance is due in full. There are many negative consequences of default.
- You can avoid default by working with your lender. If you’re unable to make regular payments according to your billing schedule, promptly contact your lender to discuss payment arrangements.
- extend your repayment term.
- Many education loans are set up to be repaid within 10 years. You may decide you want to apply to extend your loan payments out over 25–30 years. If you’re eligible, this will enable you to make lower monthly payments. However, lower monthly payments over a longer repayment term mean higher estimated interest charges over the life of your loan.
pay a bit extra with each payment.
Once you begin repaying your loan:
- each payment first goes toward paying the interest that has accumulated. The amount of interest taken from each payment depends on:
- the number of days between your payments
- the amount of principal that remains on your loan
- your interest rate
- the remainder of each payment goes toward reducing your principal.
Assuming you make regular payments on time, the principal balance decreases over time with each payment you make. When your principal balance reaches $0, you have successfully paid your loan in full.
If you pay even a little bit extra with each payment, you pay off your loan more quickly and help reduce your total estimated interest charges.
This is because you reduce your principal balance more quickly. This lowers the interest that is calculated, and thereby lowers the total cost of your loan.
There is never any penalty for prepayment (paying off your loan before your payment period is up).