Student loan interest does not require you to answer the door before Welcome to my Home; it comes into your home, eats up all your food, and sends you a monthly bill. The most important thing to understand about student loans is that regardless of whether you are paying attention to them, or how busy your life may be, interest on student loans will still be accumulating! To illustrate this, let me share with you my experience.
Near the end of my student loan repayment period, or shortly thereafter, I sat down and determined the total amount of interest I had paid on my loans. This was not the “monthly payments” that I received from my lender; it was the amount of interest that was accumulating daily on my loan. I was shocked! I had never thought about my loans as “rent” that I owed my lender; I only ever thought of my loans as being an expense that I had to repay. When you consider that your student loan is accruing interest at the same rate as your mortgage, it becomes clear that your student loan balance is growing exponentially.
When you take out a student loan, you may be focused on your schoolwork or preparing for exams, but in the background, your loan balance is increasing with interest; you won’t receive any email reminders or notifications to let you know that your loan is growing. You just see your loan balance increase, and it continues to increase until you pay it back. This is exactly what interest is doing; it’s growing your loan balance every day. The interest amount is determined by two variables: (1) the amount of the loan that you receive, and (2) the rate of interest on that loan.
The combination of an excessive loan and a high-interest rate will equal pain. A small loan and a low-interest rate will be manageable.
Your Choice: Predictability vs. Surprise
Fixed interest rate loans will have the same rate throughout the entire term of the loan and remain fixed regardless of economic changes or fluctuations. You know exactly what your monthly payment will be for the entire term; therefore, your monthly payments will be boring but will remain secure and predictable.
Variable interest rate loans fluctuate according to the economic environment. These interest rates are initially lower and may appear more attractive until they increase to higher levels. When this occurs, your monthly payment will significantly increase without much warning.
Typically, when looking for stability versus surprises, the fixed rate option is preferable.
Government Student Loans are Different from Private Student Loans
Federal student loans have a fixed interest rate for every borrower. At the beginning of each school year, a federal agency will set a new fixed interest rate for all new borrowers. Once a borrower has taken out a loan with a federal agency, the interest rate is fixed for the life of the loan. Therefore, if a federal interest rate were ever to go up or down, your loan would remain at the same interest rate.
Private lenders offer fixed or variable interest rates, and they have discretion on what interest rates to charge based on an individual’s credit score, financial history and sometimes, the financial position of a co-signer.
Although it is possible to find a good interest rate with a private lender, most private loans carry higher interest rates than federal loans. Therefore, special care should be taken when evaluating your options for student loans.
The higher the rate, the more money will be lost over time.
The Difference Between Subsidized and Unsubsidized Interest
This is where many borrowers get it wrong when they first start borrowing from the federal government.
For instance, some federal student loans are subsidized, which means that while you’re in college, the federal government pays for all your interest. On the other hand, other federal student loans are unsubsidized and start accruing interest immediately (even while you’re still in school).
With private loans, you are always paying interest, with no exceptions.
Suppose you borrow $20,000 at 4.5% interest.
- Your interest expense for each year is approximately $900.
- Your interest expense for each month is approximately $75.
- Your interest expense for each day is approximately $2.47.
Approximately $2.47 daily could purchase a cup of coffee every day until you pay off your student loans.
After thinking about it this way, I could not go back. After finally figuring out that I was losing $900 to interest payments each year, I became motivated to pay additional amounts towards the principal balance of my student loans. I realized that time is crucial when you’re paying off your student loans.
Students can experience dollar-for-dollar increases each day, week, month, and year due to compounding interest if they are in school or after graduation. While student loan interest isn’t evil, ignoring student loan interest can be very costly. Understanding how interest works allows you to reclaim your financial independence no matter what type of federal or private student loan you have, if you have fixed interest rates or variable interest rates, or whether you have a subsidized or unsubsidized student loan.
Once you understand how student loan interest works, you will be able to achieve the financial independence you desire. So, how much in interest are you currently paying?
