What Increases Your Total Loan Balance? Student Loan Interest Explained

Like just about every other type of credit, student loans charge interest for the privilege of borrowing money. But while student loans are less expensive than, say, credit cards and personal loans, they can still cost you thousands or even tens of thousands of dollars when all is said and done.

In some situations, student loan interest can even increase how much you owe. Here's what you need to know about what increases your total loan balance and how to avoid that fate.

How does student loan interest work?

When you take out a student loan, interest starts accruing on your loan as soon as it's disbursed. That means, even if you don't have to start making payments until after you leave school, your balance is already increasing. The same happens during periods of forbearance and deferment later on.

As you near the start of your repayment period, your student loan servicer or lender will capitalize the interest that accrued during the time that you didn't need to make payments.

This process results in the interest amount being added to your loan balance. There are a couple of ways to keep that from happening.

The first is to get subsidized federal student loans. These loans are reserved for students who exhibit financial need, and they're limited to $5,500 per year, depending on the year of school you're in, and $23,000 total. With these loans, the federal government pays your accrued interest while you're in school as well as during the grace period and future deferment periods.

The other way is to make interest-only payments on your student loans during periods when full payments aren't required. That way, you can avoid ultimately paying interest on top of interest once you start making payments.

Capitalized interest example

To give you an idea of how capitalized interest works and how it affects you, let's say you borrow $5,000 for your first academic term. That loan won't come due until six months after you graduate, and assuming it takes you four years to complete your program, that means interest will accrue on the debt for 54 months. 

If you have a 6% interest rate, you'll have roughly $25 in monthly interest. Over 54 months, that's $1,350 that will be added to your balance, resulting in $6,350 in total debt.

If you then pay down that debt on the 10-year standard repayment plan, your monthly payment would be $71, and you'd pay $2,110 in interest. 

Now, if you were to pay off the interest that accrues every month, it wouldn't be capitalized, so your balance at the start of your repayment period would be the original $5,000. In this scenario, your monthly payment would be just $56, and you'd pay $1,661 in interest, saving you $449.

Keep in mind that this process will be repeated for each loan you take out throughout your time in school, so the potential savings if you make interest-only payments while you're in school could easily climb into the thousands of dollars.

Your student loan balance can increase on an income-driven repayment plan

On a traditional student loan repayment plan, your balance is amortized over a set repayment schedule. With this arrangement, a portion of the payment goes toward paying the interest that accrued since the last payment, and the remainder pays down the principal balance of the loan.

If you're on an income-driven repayment plan, though, your monthly payment is calculated as a percentage of your discretionary income, which is the difference between your annual income and either 100% or 150% — depending on the plan — of the poverty guideline for your family size and state of residence. 

Depending on your loan balance, interest rate and the new payment amount on an income-driven repayment plan, it's possible that your new payment won't be enough to cover the interest that accrues every month.

The result is that, although you're still making monthly payments, your balance will continue to increase instead of going down.

A bit of silver lining to this issue is that income-driven repayment plans also extend your repayment term to 20 or 25 years, depending on the plan. Once you've completed your term, any remaining balance will be canceled. 

So if your income doesn't increase significantly over that time, you may not have to worry about that increasing balance. But if your low-income situation is temporary and your income goes up again to the point where forgiveness is unlikely, the short-term relief income-driven repayment provides will end up costing you in the long run.

How to Reduce How Much Interest You Pay on Student Loans

Since interest is what increases your total loan balance, you may be wondering if there are ways to cut your interest costs. Here are some options to consider:

• Borrow less money: Look for other ways to pay for college so you can limit how much you borrow. Options include working a part-time job, getting a scholarship or grant, and asking your parents for help.
• Shop around for private loans: If you're applying for private student loans, consider using Juno to help you negotiate lower interest rates on both undergraduate loans and graduate loans.
• Look for interest rate discounts: Some student loan servicers offer interest rate discounts for things such as setting up autopay, having an existing relationship with the bank or credit union, and paying on time for a set period. Check with your servicer or lender for discount opportunities.
• Refinance your student loans: Refinancing your student loans after you graduate could help you score a lower interest rate and save money on total interest charges. Keep in mind, though, that rates are typically based on creditworthiness, so you may need a cosigner to help you secure more favorable terms. Juno can help you with student loan refinancing by negotiating directly with lenders on your behalf.

Whichever path you take, it's important to be aware of what increases your total loan balance on student loans and the different ways you can work to improve your situation and save money along the way.