Lori Meadows
Student loan repayment is a complex topic, and deciding whether to pay interest or principal first can be challenging. Most student loans accrue interest over time, resulting in borrowers paying more than the borrowed amount. While some loans allow interest deferment during studies or at the beginning of one's career, regular payments on both the principal and interest are expected after graduation. Understanding the difference between principal and interest payments is crucial for effective financial planning. The principal is the original amount borrowed, while interest is the cost of borrowing the principal, expressed as a percentage. This added interest means that borrowers will repay more than the initial loan amount.
| Characteristics | Values |
|---|---|
| Interest accrued on federal direct subsidized loans while in college | Paid by the Department of Education |
| Grace period for federal direct subsidized loans | 6 months after graduation |
| Interest on federal direct unsubsidized loans | Begins accruing as soon as the loan is disbursed |
| Grace period for federal direct unsubsidized loans | None |
| Interest on Direct PLUS Loans | Begins accruing as soon as the loan is disbursed |
| Grace period for Direct PLUS Loans | None |
| Interest on private student loans from ELFI | Depends on the repayment option chosen |
| Repayment options for private student loans from ELFI | Immediate, Interest Only, Fixed, Deferred |
| Immediate repayment option criteria | Working while in school and can afford the payments; want to pay the least amount of interest possible |
| Interest Only repayment option criteria | Cannot afford to make full payments but want to minimize interest charges; working part-time or have some income while in school |
| Fixed repayment option criteria | Money is tight while in school but want to reduce interest that accrues |
| Deferred repayment option criteria | Cannot make any payments while in school |
| Debt avalanche method | Focus on the loan with the highest interest rate first |
| Debt snowball method | Focus on the loan with the smallest balance first |
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What You'll Learn
Prioritize high-interest loans first
If you're looking to save money, paying off high-interest loans first is a good strategy. This approach, commonly known as the avalanche method, involves making the minimum monthly payments on all your credit cards and loans, but putting any extra money towards the card or loan with the highest interest rate.
The avalanche method is a smart move because it helps you tackle the costliest debt first. However, it may not be the best option for everyone. For instance, if you have multiple accounts with similar interest rates, or if you have a large balance that feels impossible to pay off, you might consider other strategies.
One alternative strategy is the snowball method, where you pay off your smallest debt first and work your way up to the largest one. This approach can be motivating because paying off a debt in full incentivizes you to keep going. However, it may take longer to become debt-free, and you could end up paying more in interest.
Another factor to consider is your credit utilization ratio, which is the amount of your credit limit that you're using. If you have revolving debt that's using up a high percentage of your limit, prioritizing its payoff could stop your credit score from falling. This might be important if you plan on applying for a mortgage or other financing soon.
In the end, the decision of whether to prioritize high-interest loans or principal first depends on your financial situation and personal preferences. If saving money is your main goal, the avalanche method is a good choice. But if staying motivated and improving your credit score are more important to you, the snowball method or focusing on your credit utilization ratio might be better options.
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Understand how interest accrues
Understanding how interest accrues on your student loans is essential for effective financial planning. Here are some key points to consider:
Firstly, it's important to distinguish between the principal and the interest on your student loans. The principal is the original amount of money you borrowed, while the interest is the additional cost you incur for borrowing that money. Interest rates can vary, and different loans may have fixed or variable interest rates. Fixed interest rates remain constant throughout the loan period, while variable rates may fluctuate based on market conditions.
When it comes to student loans, interest typically begins accruing as soon as the loan is disbursed. This means that even while you're in school or starting your career, your loan is accumulating interest. However, some loan types, such as federal direct subsidized loans, may offer a grace period during which the government covers the interest. It's important to understand when interest starts accruing on your specific loan type.
The accrual of interest can significantly increase the total amount you repay over time. For example, a small difference in interest rates can result in a substantial difference in the total interest paid. Additionally, the longer it takes to repay the loan, the more interest accrues, increasing the overall cost.
To minimize the impact of interest accrual, it's advisable to make payments towards your student loans as early as possible. This can be done through various repayment options, such as immediate payments, interest-only payments, fixed payments, or deferred payments. Immediate payments allow you to start paying both the principal and interest right after the loan disbursement, minimizing the total interest paid. Interest-only payments cover the accruing interest while you're in school, reducing the interest burden later on. Fixed payments, typically a flat rate like $25 per month, help chip away at the interest during your studies. Deferred payments allow you to postpone payments until after graduation, but interest continues to accrue, increasing the total cost.
By understanding how interest accrues and exploring repayment options, you can make informed decisions to minimize the overall cost of your student loans.
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Loan refinancing options
When it comes to student loan refinancing options, there are several factors to consider. Firstly, you can choose to refinance all your student loans or just a portion of them. For instance, you might opt to refinance only your private loans while retaining federal loans to preserve benefits like income-driven repayment plans or forgiveness options. Refinancing with a private lender will cause you to lose benefits associated with federal loans, so this is an important consideration.
The best refinancing option for you will depend on factors such as your credit score, income, loan balance, and whether you apply with a co-signer. If your credit score and income are low, you may not qualify for favourable rates and could end up paying more. Applying with a creditworthy co-signer can boost your chances of approval and help you secure better terms.
It's important to compare refinancing options from different lenders, considering not just the interest rates but also repayment terms and monthly payments. Some lenders offer flexible terms and competitive rates, allowing you to customize your loan to fit your life. You can also choose between fixed and variable rates, with fixed APRs generally ranging from 3.99% to 10% or higher, and variable APRs from 4.35% to 11.38%.
Keep in mind that refinancing may slightly reduce your credit score temporarily due to the hard credit check, but building a history of on-time payments on your new loan can improve your credit over time. You can also refinance multiple times if you qualify for better rates or want to change your repayment terms.
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Payment plan options
When it comes to student loan repayment, there are various payment plan options available. Here are some strategies to consider:
Income-Driven Repayment (IDR) Plans
These plans base your monthly payments on your income, which can be advantageous if you're just starting out in your career or have a variable income. IDR plans offer flexibility, and you may even qualify for a $0 monthly payment. Additionally, enrolling in direct debit can reduce your interest rate by 0.25%. Keep in mind that contributions to a 401(k) can decrease your payments under an IDR plan.
Public Service Loan Forgiveness
If you're employed by the government or a non-profit organization, or serve in the military, you may be eligible for public service loan forgiveness programs. These programs can provide significant relief, but be sure to review the specific requirements and conditions.
Deferment and Forbearance
If you're facing temporary financial challenges, you can request a pause in payments through deferment or forbearance. During this time, interest will continue to accrue, so it's wise to make interest-only payments if possible to prevent it from compounding.
Loan Consolidation
Consolidating your loans can be a faster way to resolve a defaulted loan, especially if you're planning to return to school soon. However, the default will remain on your credit report.
Loan Rehabilitation
If your loan is in default, rehabilitation allows you to bring it back into good standing after 9 months of reasonable payments. This option can improve your credit report and restore your eligibility for federal student aid. Remember, a defaulted loan can only be rehabilitated once.
Target Highest Interest Rate Loans
If you have multiple loans with varying interest rates, focus on paying off the loans with the highest interest rates first. This strategy can save you money in the long run, as those dollars are more expensive to owe.
Remember, it's important to review your specific loan terms and seek advice from your loan servicer or a financial advisor to determine the best payment plan option for your situation.
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Principal-only payments
Making principal-only payments on student loans can help speed up the payback time and lower your overall borrowing costs. This is because interest on a student loan is calculated daily on the principal balance at that time, so the less principal there is to pay, the lower your interest costs. However, lenders typically apply extra payments toward outstanding fees and interest before the principal. Therefore, to make sure that your payments are applied to the principal, you may need to specify this with your lender.
There are several ways to do this. Firstly, if you pay your student loans by cheque, you can include "Apply to Principal" on the memo line for any extra payments. Secondly, you can check your lender's online portal, as this may allow you to specify how you want your extra funds to be divided. Thirdly, you can call your lender directly and ask them to make principal-only payments on your student loans.
It is important to regularly monitor your account statements to confirm that your payments have been applied correctly.
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Frequently asked questions
The principal of your loan is the amount of money you borrowed to pay for your education. Interest is the added money that accrues over time, which means you will end up paying more than you borrowed.
If you pay your student loans by cheque, include "Apply to principal" on the memo line for any extra payments. You can also call your lender directly if you can't specify online how extra funds should be allocated.
It is important to pay off both the interest and principal on student loans. Loan servicers typically consider your standard monthly payment to be applied to any fees first, then to interest charges, and then to the principal balance. If you have multiple loans, focus on the highest-interest loan first.
