Whether you're a student or a parent, if you're using loans to help pay for college, you know you'll have to pay back the amount you borrowed—but you may not have thought about how interest can make those loans cost even more.
Interest is like a surcharge for renting money. Once you understand how it works, you can determine the true cost of your loans—and even save yourself some money.
How The Costs Add Up
The cost of borrowing money isn't calculated as a flat fee. It's charged as an annual percentage of the total amount you borrowed, and then it's added to your monthly bill. Your interest rate can be fixed or variable, but either way, it will increase the amount you owe.
To figure out how much interest you'll accrue over the course of a year, multiply your loan's principal balance times its interest rate. As you repay a loan, that amount will shrink because you'll have paid off more of the principal balance the interest rate is multiplied against.
For instance, let's say you owe a $10,000 student loan with a 4.45% fixed interest rate. With the standard, 120-payment plan, you'd pay about $103 each month, for a total cost of $12,407. So, over the course of 10 years, you'd pay $2,408 to rent the money. Here's how this breaks down if you pay your loans consistently:
After 1 year
After 2 years
After 3 years
After 4 years
After 5 years
After 6 years
After 7 years
After 8 years
After 9 years
After 10 years
Borrowing For Several Years
Most students don't borrow $10,000 all at once and then start paying it back right away. They go to school first, and most degree programs are longer than 1 year. So, what if you borrow $5,000 a year for a 2-year degree?
Let's say each $5,000 is an unsubsidized Stafford loan with the same 4.45% interest rate we mentioned before, and you postpone payments on both until you leave school. Unsubsidized loans accrue interest before you start repaying them. Because of this, your first loan's balance would increase to $5,222.50 after a year. At the end of year two, that loan would accrue another $222.50 in interest (bringing its total to $5,445) while your second loan would cost $5,222.50—meaning you now owe that $10,000 in principal plus $667.50 in interest.
Now, here's when loan totals can really start growing. When you enter repayment, interest capitalizes (it gets combined with the principal), which means you start accruing interest on top of your interest. So, in this case, you're paying interest on a $10,667.50 balance, not just the $10,000 you borrowed. As a result, repaying that amount under the standard 10-year repayment plan would now cost you $13,236 over 10 years, instead of $12,408.
How To Cut Your Interest Costs
If you want to owe only the $10,000 you borrowed, you can pay the interest while you're in school. That's $189 in the first year, or about $15.75 a month.
When you're in school, an in-school deferment is usually applied automatically to pause your payments. So, if you want to pay your interest during this time, you'll have to set the payments up yourself. Contact your loan servicer (their contact information will be on your student loan paperwork) for details. You can usually do this online.
Parent PLUS loan borrowers can request a similar delay (and use a similar tactic), pausing their payments until 6 months after the student using the loan graduates, withdraws, or drops below half-time enrollment. Otherwise, repayment starts 60 days after the school fully disburses the loan.
Adding It All Up
Before you borrow loans to pay for school, think about the long-term cost and calculate whether you'll be able to afford it.
The total loan amount you'll pay over 10 years is always included in your student loan disclosure statement. But if you have trouble making your standard monthly payment, you may need to use one of the many other available repayment plans to make your payments more affordable. These options are great if you need to reduce the amount you owe each month, but be aware that they're likely to increase the amount of total interest you'll pay over the life of your loan.
However, if you start repayment early or make extra payments, you'll save money over time by paying less in interest. Try to make monthly payments to at least cover the interest that accrues while you're in school. If your loans are already in repayment, see if you can pay a little more toward your principal balance each month—or make one extra payment per year. Little changes like this can make a big difference in the total cost of your loan.