Paying back a loan sounds like a straightforward task. You make regular payments and watch your balance go down, right? Enter “Interest Capitalization.”
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In some situations, the interest charged on your loan can increase the amount owed. Here’s how it works. When you take out a student loan (or a mortgage), interest starts accruing right after it’s disbursed. Some lenders extend a grace period of 6 months after graduation before demanding payment. So even though you don’t have to start paying it back yet, your balance is increasing. This also happens when you defer or miss payments which adds a late fee to your overall loan balance.
As your loan becomes due, your lender will capitalize your interest (add the accrued interest to the original balance). Let’s take this example; if you borrowed ,000 at a 6% interest rate, due 6 months after graduation. By that time, the interest will have accrued for 54months at $10 per month. That’s $540 that will be added to your balance, resulting in $2,540 in total debt.
However, If you paid off the accrued interest every month, the lender can’t capitalize it. The loan balance at the beginning of your repayment period remains the original $2,000. Paying this amount over a standard 10-year repayment period will be cheaper than with the capitalized interest.
Remember that this is repeated for every student loan you take, so imagine the savings you’ll pocket by making interest-only payments during your student tenure.
With that being said, this is not the only way your loan balance can increase. This post elaborates on other causes that may result in your loan increasing.
The Income-Driven Payment Plan
Unlike a standard repayment plan with a set schedule, an income-driven payment plan derives your monthly payment as a percentage of your annual income. On a standard payment plan, the monthly payment goes towards the interest accrued from the last payment, and the rest goes towards your principal. However, on an income-driven plan, it is possible that your balance continues to increase as the new payment will not be enough to cover the accrued monthly interest.
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In the long run, the relief that comes with paying what you can afford will cost you.
Delays in Repayments
The longer you wait before starting to pay your loan, the higher your balance will be. From the example above, waiting to pay your loan after graduating and getting a job increases the $2,000 loan to $2,540.
Paying Less than Requested Amount
Paying less than the required amount will likely not be enough to cover both the capitalized interest and principal payments. Your loan, therefore, increases in value.
For instance, your student loan is $2,000 at 5% interest with a 10-year loan term. If you pay $50 at the end of the year, the remaining balance will be $1,950. The interest, which is $100, will bring the loan value up to $2,050.
Reducing your debt will require you to pay more than $150 as this will cover both the principal payment and interest. Your Resource For Everything Finance
Deferring Payments
Lenders do give their borrowers a grace period. Interest capitalization continues to occur, whether it’s the 6-months on the student loan to get a job or it’s a government-mandated one due to hard economic times. Your loan continues to grow in value.
Extended Payment Plan
An extended monthly plan offers a smaller required monthly payment and lasts for 20 years or more. The lesser you have to contribute to your loan every month, the more time it takes, and the higher the interest you pay. Eventually, the accrued interest will compound, increasing your loan value.
Calculation Errors
Like with all other things in life, errors can occur. There can be miscalculations due to system errors and payments to wrong accounts. If your balance is rapidly rising even though you’ve been making payments, be sure to inquire with your lender.
How To Lower Your Loan Balance
Here are a few options to offer your pocket some relief.
- Set up automatic recurring payments
Never miss a payment or be charged late fees again. Some companies offer some incentives to customers who set up automatic recurring payments. So, in addition to avoiding late fees, you might also reduce your monthly balance.
- Consider a shorter repayment term.
A repayment term can considerably impact your loan. If you can afford to make higher monthly payments, consider taking a shorter repayment period. You’ll cap the interest rate you need to pay and clear your loan faster. If you prefer making lower payments, pick a longer repayment term. Be warned, however, that you will accrue more interest. Consider the two options and choose the one best for you.
- Pay more than the bare minimum.
It’s simple math. Paying more will reduce your balance faster. The more you pay and the faster you pay it, the more you save on making higher accrued interest charges. So if you can afford to pay more than the bare minimum, do it.
- Seek loan forgiveness and payment options
If you’re struggling to pay your monthly loan repayments, consider exploring other options like student loan forgiveness or new payment plans. Many private organizations offer debt consolidation (a process where all your loans are combined into one debt). So instead of making multiple payments to different lenders, you pay only one monthly payment at a considerably lower interest rate, reducing your financial obligation and providing a smoother repayment process.
Conclusion
There are quite a few reasons your overall loan keeps increasing in value. The silver lining, however, is that there are ways to lower your balance and avoid the overbearing capitalized interest charges.
Before you commit to your new creditor, exploring these options might help you pick a loan with better repayment terms. If you’re already a student loan beneficiary, considering these options will help you understand why your loan value is continually rising and find where to save on paying extra and reduce your loan balance.
