You typically anticipate loan balances to decrease over time as you make payments. Unfortunately, even if you make payments on your loans, they may still increase.
Moody’s found that five years after starting to repay their loans, nearly half of student loan borrowers are still in debt.
In this article, we’ll look at what causes your total loan balance to rise, what interest capitalization is, and how to avoid it. Who, after all, wants to spend the rest of their lives repaying a student loan or any other kind of loan? What Increases Your Total Loan Balance?
What Makes Loan Balances Go Up?
Most of the time, loan issuers will design your repayments so that the size of the outstanding balance will gradually decrease. Progress will be initially slow due to capitalised interest.
However, the balance will decrease along with the loan’s overall value. You will eventually make only a small amount in interest payments and repay the loan in full.
By definition, adding unpaid interest to the principal (the initial amount you borrowed) results in an increase in both the principal and the amount of future interest you will be required to pay.
The loan term determines how quickly you must repay. Federal student loans, for instance, have a standard repayment period of 10 years, whereas private student loans have a standard repayment period that ranges from five to fifteen years.
But a number of things, some of which you might not normally think about, can halt your loan repayment progress. Now let’s talk about what drives up the total amount of your loans.
Paying Less Than the Requested Amount
Even if you are investing money into your loan, it may still appreciate if you pay back less of it than was requested.
How does a loan’s interest capitalization impact it? It causes the balance still owed to grow exponentially.
Let’s say you have a $40,000 student loan with a 5% interest rate. The loan has a 20-year term. At the end of the first year, if you repay $1,000, the principal will be reduced to $39,000.
However, after the $1,000 repayment, the lender will add $2,000 in interest, bringing the total loan amount to $41,000.
You must pay back your student loans on time each month in order to reduce your debt. This payment must include both the principal balance and the capitalised interest.
For the aforementioned example, that would entail spending more than $3,000 annually.
Delays in Paying the Loan Back
Typically, you don’t start making payments on a loan right away. Depending on the loan’s goal, there is instead a delay.
For instance, the majority of students do not make loan payments while enrolled in school. As a result, their loans increase as a result of interest capitalization while they are in school.
For instance, a $40,000 loan with a 5% annual interest rate will balloon to $48,620 over the course of four years when compounded annually.
Therefore, your loan balance will probably be significantly higher than it was in your freshman year when it comes time for your final exams.
Missing or Deferring Payments
Deferring payments or using forbearance (where you temporarily stop making payments) will capitalise a loan, or increase its value, just like paying less than the requested amount.
Before requiring loan repayments from students, lenders typically give them a grace period of six months after their studies are completed. This allows them enough time to look for employment, begin making money, and cover some of their initial expenses.
The loan’s interest, however, still accrues even during the grace period.
Federal income-driven repayment plans instruct borrowers to pay back as much as they are able to, based on their monthly income, rather than the amount necessary to pay off their outstanding student loans.
This results in balances gradually increasing over time because loan repayment amounts are occasionally lower than interest rates.
Choosing an Extended Payment Plan
Loans with extended payment plans typically take 20 years or longer to pay off in full. These usually result in a gradual, much more gradual reduction in loan size.
You end up owing lenders a lot more interest when you spread out your payments over a longer period of time. In exchange, the monthly payments are lower, which increases your current disposable income.
Once more, if you don’t make your extended plan payments, your total loan balance could go up. Because payments typically only cover interest plus a small amount extra during the first few years, this is the case.
You might end up back where you were if you miss just one payment a year.
Finally, calculation errors may result in balances or loan capitalization rising. Question it if you notice that your balance suddenly rises even though you’ve been making all the right payments.
Numerous factors, such as incorrect payment amounts, algorithmic mistakes, or account confusion, can cause issues.
How To Lower Your Loan Balance
You must do the following to reduce your outstanding loan balance:
Make Extra Repayments
You are not required to follow the repayment schedule established by the lender. Extra payments are always an option. The sooner you pay off your principal, the better.
When you make additional payments, you first cover the cost of any account administration fees. (These are typically quite low.) The interest is then paid off, followed by the principal.
Even minor increases in monthly loan repayments can result in significant long-term savings.
Find a Lower Interest Rate
When it comes to loan repayment, the principal is rarely the issue. Instead, it is interest capitalization that causes financial hardship.
Charging students 5%-7% per year makes it difficult to repay loans, especially in the early stages of their careers when they are earning the least.
Shopping around for lower interest rates can be extremely beneficial. Many lenders offer domestic students interest rates of less than 3%, making loans much more manageable.
For example, at 3% interest, you’d “only” have to repay $1,200 per year to keep the balance constant. More would reduce the principal, reducing your future payments.
Become a REPAYE Plan Member
Sign up for the REPAYE plan if you’re on a federal income-driven plan and your monthly payments are less than the interest on your loan.
This waives half of the unpaid interest that would otherwise be capitalised each month, making your loan more manageable. For example, if your monthly interest on your balance is $100, this facility will reduce it to $50.
Get a Temporary Interest Rate Reduction
While public lenders typically offer the lowest interest rates on student loans, some borrowers may be able to find additional relief by turning to private lenders.
Many offer rate reduction programmes that allow you to temporarily lower your loan’s interest rate, allowing you to pay off more of the principal.
Pay Back Your Most Expensive Loans First
When repaying a loan, always start with the most expensive one. That is most likely your student loan for the majority of people (unless you have credit card or personal loan debt).
Remember that you can’t get out of student loans, even if you declare bankruptcy, so repaying them as soon as possible is a priority for your financial security. In some cases, prioritising your student debt over all other loans may be worthwhile.
How To Avoid Paying Capitalized Interest
What happens when the interest on your loan is capitalised? In general, it means that you must repay more, sometimes to the point where it becomes unsustainable.
To keep capitalised interest from accruing on your loan, you must do two things:
- Pay off interest before it is added to your balance by the lender.
- Start paying off your loan while you’re still in school if possible.
Making larger monthly payments during the grace period is necessary to pay off interest prior to the lender adding it to your balance.
You can counteract the potential increase in interest by raising your repayment amounts.
Also take into account making early repayments to avoid loan interest accruing while you are a student. You can fund this out of savings or by taking on a part-time job while you’re in school.
You can end up saving a significant amount of money over the course of the loan if you identify the early causes of your total loan balance increase.
How can you reduce your total loan cost?
By paying on time, beginning your loan repayments early (including while you are still a student), and switching to a loan with a lower interest rate, you can lower the loan charge capitalization, or the amount of interest you are charged.
What happens when interest is capitalized on your loan?
When you don’t pay back your loan, interest accumulates, raising the overall amount you must repay. The term “loan capitalization” or “capitalised interest” refers to this additional interest.
What is capitalized interest on a student loan?
The sum of the principal balance plus compound interest is referred to as capitalised interest. With a principal of $40,000 and a rate of 5%, for example,
After a year, the balance due in full, including compound interest, is $42,000. Therefore, $42,000 x 0.05 = $2,100, which is more than the previous captalized interest.
What is the difference between capitalized and accrued interest?
We are actually talking about very subtle meaning differences when comparing capitalised interest to accrued interest, most of which relate to the speaker’s perspective and the context.
Both types of interest accrue, or accumulate, and are added to the principal, which raises both the principal and the amount of future interest that must be paid on it.
However, capitalised interest is something you’ll come across when reading about loans and what raises your total loan balance, whereas accrued interest is something we typically discuss in the context of savings accounts.
For businesses, the distinction lies in whether interest is recorded as an expense in the current period (accrued interest) or as a component of the loan balance.