A Tutorial on Repaying Your Student Loans

In Paying for College on Apr 13, 2016

Understanding student loans is hard enough, but repaying them can be even more confusing. 

After a student graduates or drops below half-time enrollment, his or her loan will enter a grace period before repayment begins. Typically the grace period is 6 months, but some loans have a longer grace period.

The lender will send the borrower a coupon book or monthly statement that specifies the monthly payment on the loan. The monthly payment will be calculated through a process called loan amortization. This determines the monthly payment amount that is sufficient to pay the interest and repay the principal balance over the term of the loan.

The most common repayment plans involve level amortization, where every payment is the same amount. Some loans offer alternate repayment plans, like graduated repayment and income-driven repayment. With graduated repayment, the monthly payment starts low and is increased every 1-2 years. With income-driven repayment, the monthly payment is based on the borrower’s discretionary income and not the amount owed. Most private student loans do not offer income-driven repayment.

Payments are applied first to the interest that accrued since the last payment, then the rest is applied to the principal balance of the loan. If you increase the monthly payment, it will pay down the principal balance quicker, causing the entire loan to be paid off sooner and charging less interest over the life of the loan. Most of the monthly payments near the start of repayment will go to interest. As the borrower makes progress in paying down the principal balance, less of each payment will go to interest and more will be applied to reducing the principal balance of the loan.

This table shows a simplified example of how much of each loan payment is devoted to interest vs. paying down the principal balance of the loan. It assumes a $10,000 loan with a 4.29 percent interest rate and a 10-year repayment term. Loan payments are reported as of the first month of each year.

Year Monthly Payment Interest Payment Principal Payment
1 $102.63 $35.75 $66.88
2 $102.63 $32.82 $69.81
3 $102.63 $29.77 $72.86
4 $102.63 $26.58 $76.05
5 $102.63 $23.25 $79.38
6 $102.63 $19.78 $82.85
7 $102.63 $16.16 $86.47
8 $102.63 $12.37 $90.26
9 $102.63 $8.42 $94.21
10 $102.63 $4.30 $98.33

Notice how it starts off with nearly two-thirds of each payment being directed to the principal balance, gradually increasing to 96 percent of each payment. A longer repayment term, however, will have a smaller monthly loan payment, with less of each payment going toward paying down the principal balance. For example, a 20-year repayment term at 4.29 percent interest starts off with 42 percent of each payment being applied to the loan balance.

As a good rule of thumb, the monthly loan payment on a student loan with a 10-year repayment term will be about 1 percent of the loan balance when the loan enters repayment. For example, the monthly payment in the example given above is $102.63 on a $10,000 loan.

Struggling to pay your loans? Here's what to do if you can't repay your student debt.

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