How Student Loans Work

In my last post, we looked at the different elements that make up a student loan. Today, we’re going to look at a student loan in action. We’re going to create a hypothetical example to see how these different elements work together.

Meet Billy. Billy is a recent high school graduate who will be attending Kent State University. In order to fund his education, Billy takes out a $10,000 loan with a 4% interest rate to help pay for college. $10,000 would be the principal and 4% is the interest rate. Interest would not accrue on the principal amount until after the grace period (which is defined in the loan contract).

After the grace period, interest starts to accrue and Billy has to pay back the loan. Billy’s interest is calculated monthly. So every month, interest is added to Billy’s principal at a rate of (4%/12). On the first month, Billy would have $33.33 of interest accumulated. If Billy were to make a payment of $100 on his loan, that $100 would first be applied to the interest. After paying off the $33.33 of interest, the remaining $66.67 is out towards repayment of the principal. After that payment, Billy now only has a principal of $9,933.33 left.

For the next month, the interest would be calculated on Billy’s principal balance, which is $9,933.33. So at a rate of (4/12%), Billy would have $33.11 due in interest. If he makes another monthly payment of $100, he would pay off the interest of $33.11 first and the remaining $66.89 would be applied to the principal, reducing it to $9,866.44. This will continue until Billy has fully paid off the principal of the loan.

Under this payment plan of $100 a month, it would take Billy just over 10 years to repay his student loans (10 years and 2 months to be exact). Billy would also have paid a total of $2,187.20 in interest. This is where the true cost of student loans is revealed. This $10,000 loan that Billy took out might look like it only costs $10,000, but it actually costs $12,187.20!

But that was just for our example. As I mentioned in my first post, the average student loan debt for a graduate of Kent State University was $31,543. The interest rate set for direct subsidized loans (we’ll discuss what those terms mean in a later post) is 4.29%. Let’s stick with a loan term of 10 years, which is the standard for repayment.

Using these figures, our “average” calculation spits out a monthly payment of $323.72. At the end of 10 years when the loan is paid off, that person will have paid an additional $7,303.76 for interest.

As you can see, the interest on a loan makes a huge difference. When looking at taking out loans, you need to factor in the total amount of the loan that includes interest, not just the principal. Our friend Billy might have thought he only had $10,000 in loans, but in reality he had to pay back much more than that!

Another interesting thing of note is that when you make a payment on a student loan, the payment is applied to the interest first, then any remaining money is applied to the principal. When talking to people about their student loans, this was something a lot of people expressed surprise about. But it’s an important fact to consider – you may make a $500 payment for your loans, but your principal will not decrease by $500. It will only decrease by whatever is left of that $500 after interest is paid. So, the more interest that accrues on an account, the harder it is to pay off the principal of the loan.

The effect of interest on student loans is not to be underestimated. The more interest that accrues on your account, the more money you will have to pay, and the longer it will take to pay back your loans. As I mentioned before, look at the interest rate and it’s projected effect when taking loans in order to get an accurate look at what your amount you will eventually have to pay back.

If there’s one thing that you’ll hopefully walk away from this with, it is that the amount of loans you take out is not the amount you will pay back. You will pay back much more. Think realistically about your loans, think of them in the amount that you will have to pay, not the amount that you received.

Here is a link to a useful loan calculator. Plug in the information for your student loans – what you find might be a little bit surprising, and maybe even a little bit scary. Maybe it will motivate you to think differently about your loans.

Well, that is all I am going to write for today. Next up on the schedule will be a comparison of the different types of student loans you can take.

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