By Drew Cloud, owner of The Student Loan Report
Most student loan borrowers take out loans that accrue interest. A small subset of federal borrowers receive a type of loan called Subsidized Stafford Loans, and the interest that accrues on those loans while the borrower is still enrolled half-time or more is paid, as it accrues, by the federal government. For more information on subsidized and unsubsidized student loans, read this explanation.
All other federal and private borrowers, accrue interest starting from the day they receive the loan funds or the funds are applied to tuition. Not many students make payments against their interest while still in school, but it’s a smart financial move and an increasing number of students are realizing it. Here are four reasons to pay your interest while still in school.
You’ll avoid capitalized interest – your loan’s worst enemy
Capitalized interest is the devil at work. Not only do you have to pay back the principal amount of your loan—the $10,000 of the original $10,000 loan, for example—plus the interest that accrues on it, but if any of your interest for the month goes unpaid then that interest is capitalized (added to the principal balance). It then accrues interest of its own! Think of unpaid interest like bunnies in a garden. If you don’t shoo it out, it just makes more of itself exponentially.
Most federal student loans and all private loans will accrue interest while you are in school and for any grace period, typically six to eight months, after you graduate. When you don’t make payments along the way, you end up paying more. You pay interest-on-interest, compounded. This means less money for you in the long run, so it pays to be disciplined with your finances and make at least interest-only payments while still in school. This is especially troublesome for private student loans with high than average interest rates on education loans. To learn more about the dangers of private education loans, read this guide.
You’ll develop good financial habits
Making student loan payments is not the easiest habit to get into. And making the larger payments of principal and interest that come due after your grace period is over can be a financial shock to your budget. Ease yourself into financial responsibility by making your interest-only payments while still in school, and that transition to larger payments won’t be so difficult to do. Not only that, but organizing your payments will help you with an overall budget if you don’t already have one—something everyone should have. Use your interest payments as an opportunity to take control of your finances. Paying them is also a continual reminder that getting student loans isn’t free money, something many borrowers know but don’t really “get” fully until the day they start to repay them. Let those responsible, interest-only payments be your monthly reminder that the less debt you take on now, the less you’ll have to repay for the next ten to thirty years.
You’ll always know how much you owe
It’s hard to make monthly payments without having an intricate knowledge of how much you owe, to which lender, and what the terms are. There’s nothing like parting with one’s money to foster a desire to know exactly where that money is going. One of the biggest reasons that borrowers overextend themselves into student debt is that they lose track of just how much money they’re borrowing each semester. After all, when you don’t make payments, it’s easy to forget that you owe anything at all. Tracking your loan information, and most especially your ongoing cumulative balance, is a way to keep on top of your debt and recognize if borrowing gets unreasonable. Then you can do something about it, such as foregoing some loan amounts and working part-time instead.
It could motivate you to pay off your debt faster
It may be hard to believe, but many students who make interest-only payments become dissatisfied with making “just” interest payments and begin to actually pay off their student loans while still in school. If you can afford to go this route, it’s an even better way to corral your debt and develop great habits before graduation. Even adding an extra $25 or $50 a month toward your principal balance will add up over time, especially if you can keep those payments going over school breaks. Better yet, use school breaks as an opportunity to earn some extra cash and put it toward your loan balance, resulting in less debt when you get out of school. Or, save that money and use it for living expenses during the next semester, which ultimately cuts down on your need for borrowing in the first place.