No one likes to see their student loan balance grow because interest payments keep adding to the total. But the good news is that it’s not really as bad as borrowers tend to think it is.
To help you get a handle on student loan interest, I sat down with our senior student loan consultant, Rob Bertman, CFP®, CFA. Bertman has been with Student Loan Planner since 2017 and is the mastermind behind Family Budget Expert.
With over 15 years’ experience as a financial planner, investment analyst and advisor, he knows a thing or two about how interest can impact your student loan debt.
How student loan interest works
“The difference between how student loan interest works versus most other kinds of debt is really fascinating,” said Bertman. “It makes a huge difference in the projections for your loan repayment.”
In the early part of your loan, the interest can seem a little scary. But as time goes on and you’re paying down the principal balance of your loan, it isn’t bad at all.
First, let’s dive into how compound interest works. Then you’ll see how different student loan interest is.
How compound interest works
Compound interest is great if you’re investing because your balance can grow more quickly than with other kinds of interest. But when you’re borrowing money and paying compound interest on a loan, it can work against you.
For instance, let’s say your loan balance is $100,000, and your interest is 7%. If you don’t make any payments, your balance will go up to $107,000 after a year because you’d be charged $7,000 in interest.
But the next year, you pay interest on $107,000, not $100,000 like the year before. In the second year, your interest adds up to $7,490, and your balance grows to $114,490 to account for the additional interest.
By year 10, you’ll end up paying $12,869 in interest alone that year, which is almost double the amount of interest you started with in year one.
How student loan accrued interest is different from compound interest
Student loan interest is different because it is accrued interest. Accrued interest is different in that you’re not charged interest on your interest like you would be with compound interest.
If you have $450,000 in student loan debt at a 7% interest rate, for example, your first-year interest charge will be $31,500. That interest is still added to the loan, but “whatever the payments don’t cover, it picks up that interest and drops it in a separate bucket,” said Bertman.
“And that separate bucket of accrued interest stays stagnant,” explained Bertman. “It doesn’t get charged the interest again.”
In the first year of repaying a loan, accrued interest and compound interest look identical. As time goes on, however, accrued interest will be significantly lower than compound interest.
It’s a huge difference. “The interest is advantageous to student loan borrowers compared to a compound interest situation,” said Bertman.
How subsidized interest works
One of the income-driven repayment (IDR) plans covers the cost of interest for you. On Revised Pay As You Earn (REPAYE), you get an interest subsidy. Here’s how that works:
The government will pay a portion of your loan interest if your calculated monthly REPAYE payment doesn’t cover all of it. The U.S. Department of Education describes the portion the government will cover as one of the following:
- The remaining interest due on subsidized loans for up to three years from when you start repaying under the REPAYE plan plus half the remaining interest on subsidized loans following that three-year period
- Half the remaining interest on your unsubsidized loans
Let’s say you graduate with $350,000 of principal loan debt and $100,000 of interest. Unless you have $100,000 in your pocket to pay off the interest that accumulated while you were in school, that $100,000 of interest capitalizes after you exit your grace period.
You have that one compounding event, but with REPAYE, the effective interest rate at the end of your repayment is about 1% because the interest is so subsidized in its simple rate.
Just say “no” to forbearance
Borrowers tend to opt for forbearance early in their careers. It happens “much too often,” said Bertman.
Your finances might be shaky the first few years after you graduate. If you hit a rough spot financially, you might ask your loan servicer to put off your monthly student loan payments through forbearance.
It’s human nature to extrapolate what’s going on in our lives and think the world is going to fall apart, but opting for forbearance is rarely a good idea for two reasons:
- First, forbearance always increases the total amount you owe. What happens is, every time you do a forbearance, you’re compounding your interest.
- Second, if you’re going after Public Service Loan Forgiveness (PSLF), you want to get to 120 payments as quickly as possible. If you put off your payments for six months, you’re adding six payments to the end of your loan repayment period before you’ll qualify for forgiveness.
Because you tend to earn more money later in your career, and your monthly payments are based on your income, you’ll end up paying a lot more on your loans during those last six months.
A better option is to go for an IDR plan. With IDR, your payments could be as little as $0.
Don’t freak out about your student loan interest
If you’re worried about your student loan interest, don’t be. It’s easy to think that interest will skyrocket your balance to 10 times what it is today. If you run the numbers with our student loan interest calculator, however, you’ll see that isn’t the case at all.
“There’s no other debt that I can think of that is nearly as complex and so different than other debt rules of engagement,” said Bertman.
Although student debt is a big problem, the rules that apply are better than those of credit card debt, mortgage debt or credit card debt.
“You need someone who knows the nuances of [student loan interest] to understand how this works because it is so different than anything else,” said Bertman.
Refinancing your student loans can cut down on the interest you pay, too. If you’re not doing PSLF and you have a student loan payment on federal loans that is fully covering all of your interest, you should have refinanced a while ago.
And if you can’t explain to your family or your spouse why it’s not a problem, and they’re worried about your debt, that’s when you need a student loan plan with Rob Bertman or any one of our other consultants. Getting on a good repayment plan can help you understand what your interest is and what the specifics are for your situation so you can better manage your finances.