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Today’s post was written by Nate Matherson, a ’16 college grad working to repay student loan debt, save for retirement, and co-creator of personal finance blog LendEDU. Nate launched LendEDU in ’14 as a site focused on helping students better manage student loan debt. Enjoy! ~ Jamie
One benefit of student loans is that payments are deferred while you’re in college.
This is great because you don’t have to worry about making monthly payments to a lender while going to school. You can focus on studying.
But, despite this benefit, I still worked while in school to pay my student loan interest.
It might seem like a strange concept to pay any part of my student loans while I was in school. I mean, they are deferred after all so I didn’t need to pay a dime until after I graduated.
While this was a challenge for my schedule and school/life/work balance, there was one simple reason why I did it: I wanted to save money on my student loan interest interest.
If I paid for the interest NOW, then I would have to pay so much less LATER. I didn’t want to give my interest a chance to pile up and increase the overall cost of my student loans.
What Was it Like to Work During College to Pay My Student Loan Interest?
I know a lot of people work during college. Most people need to work to pay rent and their other bills.
But I was working to pay off my student loan interest before it got out of control.
I got a job at our business school’s computer lab titled the Trading Center. Imagine Wall Street with tickers, Bloomberg terminals, glass walls… that was our Trading Center and my office for a couple years.
I was able to get this job through one of the finance professors who I had built a relationship with in the first few months of being on campus.
About 50% of the time I was on call to make sure that the computer terminals weren’t stolen, and the other 50% of the time I was there to help other students with their financial modeling, projects, and software.
I worked anywhere from 12-22 hours per week, and earned about $9.00 per hour.
It wasn’t a ton of money, but I was able to pay about $7,500 towards my student loans while I was in-school.
The most important thing was by starting to pay off my student loans while I was still in school, I saved even more money by avoiding compounding interest.
Usually compound interest is a great thing when you’re talking about investing. But since we’re talking about debt, compound interest can work against you in a very bad way.
Working to pay interest on student loans while in school can make a lot of sense because if you don’t do this, interest is capitalized.
When interest is capitalized, you pay a lot more on the overall loan than the principal amount. It gets real expensive real quick.
I’ll give a few examples later.
How Interest is Calculated on Student Loans?
One nice thing about student loans is you don’t have to make payments while you’re in college. Your loans are deferred until 6-9 months after you graduate. That’s when your student loans slap you in the face.
If you already graduated, you might still have the hand print on your cheek.
But just because you don’t have to make any payments, it’s still smart to start paying them off if you can.
Interest keeps piling up while your loans are deferred, which makes your total loan bigger.
And remember that bad compound interest we talked about earlier? As your interest grows and adds to the total value of your loan, the compound interest helps your debt grow at an accelerated rate.
This is very bad news for future you.
Should I Pay Interest on All of My Student Loans During College?
There’s good news. You don’t have to pay interest on all student loans while you’re in school.
The first thing you’ll want to do is check to see if your loans are Subsidized or Unsubsidized.
If you have Subsidized loans, you’re in luck. The government covers interest costs on Subsidized Direct Loans.
But interest will be charged on both Unsubsidized Direct Loans and private loans, including mine from Sallie Mae.
Interest is charged as soon as your loan funds are disbursed. And for both unsubsidized loans and most private loans, it’s compounded daily.
This is SO IMPORTANT because this means your principal balance gets a little bigger each and every day – and the next day, you pay interest on this higher balance. Again, compound interest working against you.
Let’s look at a simple example:
Say you borrow $10,000 at 9% (this sounds high, but I had 9% private student loans) interest that compounds daily.
Over one day, you’ll incur about 0.0002466% in interest (9% divided by 365 days in a year) or around $2.47 in interest. That doesn’t sound terrible right?
So, onto day two.
Now you’re paying the same .0002466% interest, but your new principal balance is $10,002.47. The amount you’re charged interest on gets a little bit bigger each and every day.
You still pay roughly $2.47. Again, it probably doesn’t seem like a big deal.
But remember, you’re probably going to be in college for at least 4 years. That’s 4 years of compound interest working against you.
The magic of compound interest comes with time. The longer you wait, the faster it grows.
This is beautiful for investments and saving for retirement. It’s a damn shame for student loan debt.
In four years time, your $10,000 loan could turn into $14,049.
You’re still responsible for these interest costs as a borrower, and interest keeps growing during all of those years that you aren’t making any payments because you’re in school.
And if you’re like some people and it takes you 5 or 6 years to graduate, your principal balance will only get bigger.
If you want to estimate how much compound interest your loan is going to accumulate, use this calculator.
When You Graduate Your Loans Will be Smaller if You Pay Interest During College
When you don’t pay interest on your student loans during the time you’re in school, the unpaid interest balance just keeps growing, as we just saw.
Then, at certain times, this unpaid interest is capitalized – or added to your outstanding balance.
Interest is capitalized when your deferment period ends. And if you just graduated, interest will capitalize after your grace period.
Now, your entire unpaid interest balance is added onto your student loan debt. So you now owe interest on the interest.
Let’s take a look at a real life example.
If you borrowed $10,000 your freshman year at 6.8% and your payments were deferred for 54 months. That’s the entire four years you’re in school plus an additional six-month grace period after graduation.
If the unpaid interest is capitalized at repayment, the $10,000 loan balance you initially took out would turn into about $13,060. Now your loan is bigger and you still need to pay it all back.
Extra Student Loan Interest Results in Higher Monthly Payments
Using the example above, if you’d been able to pay the interest costs during school, you’d have avoided $3,060 in interest being tacked onto your balance.
But now that an extra $3,000+ was added to your loan balance, your monthly payments will go up after you graduate.
That will definitely affect your cost of living and lifestyle once you find a job post graduation.
Most people don’t think of the monthly payments until they get slapped in the face after the grace period ends. But the truth is, the lower your overall student loan balance, the lower your monthly payments will be.
On $10,000, your monthly payments would’ve been roughly $115 on a standard 10 year repayment period.
But since your interest was capitalized, your $13,000 loan plus interest will bump your monthly payment up to $150.
And now think about if that happened for ALL of your student loans? The numbers start to get a little scary, and your post graduation salary doesn’t feel quite so big.
And, not only would your monthly payment costs be higher, but you’d end up paying more interest in repayment thanks to the fact you’d pay interest on a higher balance: $13,060 instead of $10,000.
If you didn’t pay anything towards your loan while in school (in our example), you’d end up paying a grand total of $4,974.80 in interest after paying off the loan over 10 years.
But if you worked a little and made payments during college, you would only pay roughly $3,809 in interest.
Sadly you can’t escape interest altogether since that’s what happens when you take out a loan, but I’d rather have $1,000 in my pocket than having to pay it to a loan company.
Bringing it All Together: It’s Smart to Pay Student Loan Interest ASAP
To summarize all this math, there are two major benefits of paying student loan interest while you’re still in school
- Your total loan repayment cost will be lower
- Your monthly student loan payments will be lower after you graduate
While it may be challenging, you’ll save yourself a fortune, or at least thousands of dollars, in the long-run and make post-graduation repayment more affordable.
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What do you think? Is it worth it to pay student loan interest while you’re still in school?