Student Loan Sharks! #2

Today’s Topics: Future Payments, Paying Ahead, Interest and Capitalization.

Today there is a lot to discuss and with this information you can develop a strategy for how you are going to pay off your student loan debt or at the very least, know what to expect.

I called the Customer Service number again, but this time I asked how is my monthly payment applied to my loan? And, what if I wanted to pay more than the monthly payment–how is that applied? I was shocked at what I heard and you will be too!

“All” extra monies paid above your regular payment are applied to FUTURE PAYMENTS! I was dumbstruck!!! Just as fast as the first Ninja Warrior kick came, he jumped in the air and spun around to deliver a deadly blow that left me dazed and confused. I couldn’t believe what I heard.

Let me break down the different scenarios you have probably already experienced and wondered why your balance hardly changed.

• “Future Payments” – If my monthly payment is $600 and I paid $700, the extra $100 goes toward “future payments”. You probably expected to see a $100 reduction in the principal amount, but that is not how your payments are processed. The extra $100 goes to any outstanding interest first, then principal–UNLESS you have a payment directive on file (covered in volume 3).
• “Paying Ahead” – If my monthly payment is $600 and I paid $1,200 you believe you have paid ahead 1 month. Right? Wrong. Using the same principle above your “extra payment” of $600 goes toward interest first, then “future payment”–UNLESS you have a payment directive on file. **Paying ahead may also negatively affects IDR/IBR plans.
• “Paying Ahead & My Payment Decreased” – If my April monthly payment is $600 and I paid $1,200, my June payment will show a “$0” payment. You’re all excited thinking you’ve been given a reprieve, but not so fast. Interest continues to accrue the day after your payment even though it shows a “$0” payment. You must continue to pay interest or it will capitalize (double).
• “Interest” – Your loans accrue interest every day. Remember, student loans are not simple interest loans! Ask your loan servicer how much you pay in interest “per day”, then do the math. Example $12.50 daily interest x 31 days = $387.50 per month x 12 months = $4,650 a year. This amount increases if you miss just 1 payment or pay late.
• “Capitalization” – Ever wondered why your balance is increasing and/or interest is doubling? It’s because of capitalization. Capitalized interest increases the total balance of your loan amount. How? It’s unpaid interest that is added to your student loan balance when you are in forbearance, deferment or just don’t make payments. Because of “capitalization” you’ll repay much more than you originally borrowed.
• “Capitalization Example” – You borrow $80,000 with a loan rate of 6%. After four years in deferment (you made no payments on your unsubsidized loan while in school) your interest of $21,600 is now added to the principal balance of your loan after your grace period ends and repayment begins. Now instead of owing $80,000, you owe $101,600. To make matters worse, you will be paying “interest on top of the interest of your loan!” The same principal applies if you miss a payment.
• “No Payment OR Payment Doesn’t Cover Interest” – If you fail to make a payment during the next scheduled payment, or the payment made does not cover the interest, that is when the accrued interest would capitalize and be added to the principal balance of the loan.

The confusing part for the borrower is that they think they have paid ahead when in reality it’s like the payment was sucked into the black abyss and you’ve got nothing to show for it. Furthermore, you still have to pay the next month’s payment too (you know the one that you thought you already paid) or your interest will double. You cannot afford to miss one payment!

Don’t even think about forbearance or deferring your loans either, because once the interest capitalization train begins to roll it will quickly get out of control and then you’ve got a train wreck on your hands. Basically, once you get off of deferment or forbearance, your first few months or more of payments will be applied to the interest that you have accrued and “none will be applied toward principal” until you have paid off all the interest owed first.

When most people think of interest, they think of a simple interest loan where you can pay ahead and your interest is fixed each month. To help you really know how to tackle your student loan debt, ask your student loan servicer for an amoritization schedule for your plan. You may also find an amoritization calculator online, but you need to make sure it uses capitalization versus simple interest.

There was a lot of information covered in this post, however, don’t despair as good news is on the horizon. Volume 3 will be coming out shortly–stay tuned!

*Photo courtesy of Dave Granlund.com