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How Loan Payments are Applied to Principal and Interest

Monthly student loan payments include both interest and principal like all amortizing loans. The monthly payments are applied first to late fees and collection charges, second to the new interest that has accrued since the last payment, and finally to the principal balance of the loan.

As the loan balance declines with each payment, so does the amount of interest due. If monthly payments are level, or a fixed amount, the principal balance declines faster with each successive payment.

When a student loan borrower sends in a payment to their lender, the payment is applied to the principal balance only after it is applied to the interest. If a borrower sends in more than the scheduled payment each month, the excess is usually applied to the principal balance, causing the loan balance to decrease faster and faster each month. Making extra payments will cause the loan will be paid off before the scheduled repayment term ends, effectively shortening the life of the loan and the total amount of interest paid.

For example, if a borrower has a $10,000 loan balance at the beginning of repayment with an interest rate of 5% and a 10-year level repayment schedule, they would make payments of $106.07 per month and pay $2,727.70 in total interest over the life of the loan. For the first month, the payment would be applied as follows:

$41.67 to interest ($10,000 x 0.05 / 12)

$64.40 to principal ($106.07 – $41.67)

However, if the borrower sends in $188.71 the first month, a greater proportion of the payment would be applied to reduce the loan balance:

$41.67 to interest ($10,000 x 0.05 / 12)

$147.04 to principal ($188.71 – $41.67)

If the borrower continues making monthly payments of $188.71, the loan will be paid off in only five years with total interest paid of $1,322.76.

How to Reduce the Total Interest Paid on Your Student Loans

There are several ways a borrower can reduce the total interest paid on their student loans:

Paying the interest as it accrues each month while still in school and during the six-month grace period will keep the loan balance from increasing. When repayment begins, there will be no unpaid interest to be capitalized, and the required monthly payment will be lower.

A shorter repayment period always results in less total interest paid over the life of the loan. The standard repayment term is 10 years for Federal Direct Loans, but borrowers may be eligible to choose repayment terms as long as 30 years. The repayment periods for private loans vary and are set at the time the promissory note is signed.

There are no prepayment penalties on student loans. This allows borrowers to make extra payments on their student loans without having to pay any extra fees. Making extra payments reduces the loan balance, so that more of each payment is applied to the principal than to interest. It also pays off the loan quicker, reducing the total interest paid over the life of the loans.

Finally, the amount total interest paid may be reduced by refinancing the loan at a lower interest rate. The federal government offers loan consolidation, which does not reduce the average interest rate on a borrower’s student loans. But there are many lenders who will refinance private student loans. If the credit scores of the borrower and cosigner (if applicable) have improved, the borrower might be able to qualify for a lower interest rate on a private student loan refinance.

Refinancing federal student loans into a private student loan is not recommended, as the borrower will lose access to the superior repayment benefits on federal student loans. Before refinancing federal student loans into a private student loan, the borrower should weigh the potential need for an income-driven repayment plan or desire to seek loan forgiveness. These options aren’t available with most private student loans. The fixed interest rates on federal student loans are also lower than the fixed interest rates on most private student loans.

Minimize the Interest on Interest as Much as Possible

Most student loan borrowers don’t have the income to make interest payments while they are in school. However, once student loan repayment begins, borrowers should try to avoid missing payments or seeking a deferment or forbearance. The unpaid interest would need to be repaid, along with interest charged on the interest. Conversely, accelerating student loan repayment after graduation minimizes the total interest charged on the interest that accrued during the in–school and grace periods.

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