Applying for a loan is a major step towards becoming financially responsible and making informed decisions. Before applying for a loan, it’s very important to know as much as possible about how loans work. The most important detail to remember is when you receive a loan, you are responsible for paying it back plus all interest charges. Your interest charges, your payment amounts, and your payment frequency will impact your total loan balance. Based on this, it’s possible that your loan balance may increase, even if you have been making payments. So, let’s discuss in more detail what increases your total loan balance.
A loan balance is made up of interest charges, payment amounts and the payment frequency. It’s helpful to know how each of these items work as it applies to your loan.
Loan Example
When you sign a loan agreement from a lender, you are entering into a contract that specifies certain terms and conditions. You and the lender agree to a specified loan amount, an interest rate, a repayment period and a late fee. For example, let’s say you borrowed about $30,000 as a federal student loan. The interest rate is 6%, the repayment period is 10 years, the monthly payment is $333, and the late fee is 6% of the missed payment amount.
Based on this information, we can determine the total costs of the loan. One of the most important cost factors of a loan is the interest rate.
How Do Interest Rates Work?
Interest rates represent the cost of borrowing money. In our student loan example, the interest rate is 6%. In our monthly payment of $333, about $150 is the interest and about $183 goes toward the principal or the original loan amount. Over the entire ten-year period, the amount that will be paid in interest is about $10,000. The $10,000 in interest plus the original loan amount of $30,000 brings the total repayment amount to $40,000.
In this scenario, the repayment plan has payments due shortly after the loan was received. This is not realistic for a student, because a full-time student is probably not in a position to immediately begin making payments. Students receive an in-school deferment while enrolled at least half-time in school. An in-school deferment pauses federal student loan payments until the student is no longer enrolled in school at least half-time.
Typically, with federal student loans, payments begin six months after you graduate, leave school or change your enrollment to part-time status. Even though payments aren’t due while you’re enrolled, interest begins to accrue immediately after you receive the loan. That means your total loan balance will increase every day until you graduate and start making payments.
Interest Accrual Example
In our student loan example, the interest rate is 6%. So, if you borrowed $30,000 ($7,500 per year), the loan balance will increase every day while you’re in school. If you graduate in 4 years and add the 6-month grace period, you will owe more money than you borrowed. In the 4+ years that you are enrolled in school, your loan servicer is charging you interest on your loan.
See the cost breakdown below:
- Year 1 – $7,500 x 6% = $450
- Year 2 – $15,000 x 6% = $900
- Year 3 – $22,500 x 6% = $1,350
- Year 4 – $30,000 x 6% = $1,800
- 6 Mon – $30,000 x 6% / 2 = $900 (Grace Period)
Total Interest: $450 + $900 + $1,350 + $1,800 + $900 = $5,400
The total interest amount of $5,400 accrued while you were enrolled in school. After graduation, your loan servicer will add this interest amount to your original loan amount of $30,000. Your new loan balance is now $35,400. Since your total loan balance has increased from $30,000 to $35,400, your monthly payment will also increase from $333 to an estimated $393. Your first loan payment of $393 is due starting 6 months after you graduate.
How Do Loan Payments Work?
Although you have a new loan balance and a new monthly payment, the remaining aspects of your loan have not changed. The interest rate is still 6%, the repayment period is still 10 years, and the late fee is still 6% of the missed payment amount. With your new monthly payment of $393, about $173 is the interest and about $220 goes toward the principal or the loan amount.
Over the ten-year period, the total amount of interest is about $11,762. The $11,762 in interest plus the loan amount of $35,400 brings the total repayment amount to $47,162.
As you make payments, your loan balance of $47,162 decreases over time. In this case, it will decrease by about $220 every month for 10 years until the remaining balance is $0. To shorten the loan term and reduce the amount of interest paid over time, you can make extra payments.
By paying an extra $100 per month, the entire loan will be paid off in 7.5 years. You would also save $3,198 in interest payments. By paying an extra $200 per month, the entire loan will be paid off in 6 years. You would also save $5,012 in interest payments. By paying an extra $300 per month, the entire loan will be paid off in 5 years. You would also save $6,183 in interest payments.
Making extra payments helps you to save money over time. Also, when making payments, it’s very important to make your payments on time. Making timely payments also helps you to save money on fees and penalties from late payments. There are several consequences for late payments.
How Do Late Fees Work?
If you’re late on your student loan payments, your servicer may assess fees and penalties for late payments. In our student loan example, the late fee is 6% of the missed payment amount. Late fees are typically assessed 30 days after your missed payment. So, if you missed your $393 payment, the late fee would be about $24. That would be $24 in fees plus the unpaid interest of $173 that will also be considered past due.
When you make your next payment, it will go towards fees that are owed, then to interest (including past due interest), then to the balance of your loan. When you miss a payment, your next payment has to be large enough to cover late fees and past due interest. If payments are not large enough to keep up with the fees and interest, your total loan balance will increase.
Late Payment Consequences
But it’s not only late fees and interest that apply to missed payments. If you are over 90 days late paying your federal student loan, your servicer may report your late payments to the 3 major credit bureaus. This can lower your credit scores which may impact your ability to be approved for loans in the future.
If you are over 270 days late paying your federal student loan, your servicer will begin the process of placing your loan in default. Having a loan placed in default means the borrower has failed to repay the loan according to the terms and conditions that were agreed to. Defaulting on a loan can have serious consequences. At this point, your loan servicer will place your loan with a collection agency. Collection agencies assist loan servicers with collecting past due payments. Collection agencies also charge fees associated with their services.
The maximum fee is roughly 20% of the payment amount. For example, if you paid $200 on a defaulted student loan, the collection agency would receive 20% or $40 first. Then, the remaining $160 would go toward late fees, past due interest, then your loan balance.
Late fees can add up quickly. After every missed payment, fees and interest continue to accrue. Because of this, your loan balance may increase and your credit score may decrease. Not paying your student loan on time can be costly. Falling behind on your payments can negatively impact your overall financial well-being. If possible, try to make an effort to consistently make payments on time.
What If I Can’t Make Payments?
If you are having trouble making your student loan payments, it’s best to contact your loan servicer to discuss your financial issues and review your options. You may qualify for a deferment, a forbearance, a refinance, an income-driven repayment plan or another repayment option.
A deferment is a temporary pause of your student loan payments for certain situations such as active-duty military service, unemployment and school enrollment. A forbearance is a postponement or reduction of your student loan payments due to financial difficulty.
If temporarily pausing or lowering your payments is not the best option for you, another option is to apply for an income-driven repayment plan. An income-driven repayment plan adjusts your payments to a percentage of your income to make your payments more manageable. Payments can fall between 5% and 20% of your income, and any remaining balance on your loan may be forgiven after 10 to 25 years of payments.
Another option is to refinance your student loans. Refinancing your student loans with a private lender can save you money or reduce your monthly payment. However, refinancing can be risky. Once you refinance, you will no longer qualify for income-driven repayment plans or loan forgiveness.
Furthermore, it’s important to remember that changing your repayment plan does not stop interest from accruing. If your payments are paused or reduced, interest will continue to accrue which will cause your loan balance to increase.
Summary
Taking on the responsibility of a loan is a major step towards becoming financially responsible. Managing a loan impacts your overall financial wellbeing and your financial future.
In this article, we reviewed the different aspects of managing a federal student loan. We discussed the terms and conditions that you and the lender agree to such as, a specified loan amount, an interest rate, a repayment period and a late fee.
We also discussed the factors that increase your total loan balance. Interest is the main factor, because interest never stops accruing until your loan is paid off. Making late payments, not making payments at all, and changing your repayment plan are also factors that increase your total loan balance.
Ideally, you should pay your student loan payments on time and make extra payments to save on interest and pay off your loan quicker. However, that’s not always possible. A better approach is to know your ability of paying back a loan, before you agree to the terms and conditions. Now that you know more about how loans work, you can make better financial decisions for your future.
If your financial decisions are affecting your marriage, our Marriage Repair Handbook has additional information along with our resources page.
Disclaimer: This article is provided as general information, not financial advice. It does not create an advisor-client relationship, and it’s not a substitute for seeking professional financial guidance. This site is a collection of articles that act as an advertising network for a marriage course. Do not take action based on this article without seeking professional advice from a licensed financial advisor in your state.