You’ve been making payments consistently on your student loans, but when you look at your balance, you’re surprised to see that it is still high. The reason for the high balance might be compound interest.
What Is Compound Interest?
The most straightforward definition of compound interest is that it is interest you pay on interest. However, to better understand this complicated concept and how it affects your student loans, it might be helpful to first look at how interest is calculated on your loan, and then at how your payments are applied to the principal (the original amount borrowed) and interest.
How Does Interest Accrue on a Student Loan?
When you take out a student loan, your lender will set an interest rate, which is their compensation for lending you money. Generally, the interest rate is referred to as an annual percentage rate (APR), but it is actually calculated and accrued daily. Interest begins accruing immediately after your loan has been disbursed. This is true even for subsidized student loans: Interest accrues immediately, but the federal government pays that interest while you are in school or during your grace period.
To calculate your daily interest rate, your APR is divided by 365. Let’s say you take out a $10,000 loan with an APR of 5%. Your daily interest rate is 5% divided by 365, which is 0.00014, or 0.014% daily. The first day after your loan is disbursed, you accrue $1.40 in interest ($10,000 x 0.014%). That interest is then added to your principal, which brings your new total balance to $10,001.40. The next day, the daily interest is compounded, or calculated based on the new balance rather than on your principal only.
Your daily interest amount may not seem like a lot, but at the end of the year, you will accrue $511 in interest, and often you have student loans for four years. By the time you finish school, your loan balance will be much higher than the original amount you borrowed because of the way interest is calculated and compounded.
How Does the Monthly Payment Get Applied?
With student loans, you have a fixed monthly payment. When you make a payment, the amount first goes to monthly accrued interest, then to outstanding fees, and finally to your principal. In the above example, your monthly accrued interest would be $42. If your monthly payment is $120, the payment will first go to that $42, and the remaining $78 will go to your principal, assuming no fees were assessed for that month.
Interest accrues throughout the life of your loan, so every month a little more is added to your loan balance. That is why, even though you are consistent in making payments, your loan remains high. By making extra payments, or paying more than the minimum amount monthly, you will start to see your balance decrease quicker because more of your monthly payment will be applied to the principal.
The Law Office of Simon Goldenberg, PLLC – Providing Solutions for Your Loan Debt
If you’re having difficulty managing your student loan debt, contact the Law Office of Simon Goldenberg, PLLC. We can help you understand your debt relief options. We recognize the struggle of having outstanding student loans and will work with you to find solutions that fit your circumstances.
For effective legal guidance, call us at (888) 301-0584 or contact us online.