According to the National Center for Education Statistics, debt level for graduating seniors with student loans increased by 108%, from $9,250 to $19,200, between 1994 and 2004. Those numbers are continuing to trend upward. The five or six digit debt accumulated while studying may seem like inconsequential numbers on a page now, but after graduation the terms agreed upon come into focus. Money will be owed regardless, but whether the amount you owe is a small part of your income or a small fortune often depends on the interest structure of your loan. The most common types of interest offered by lenders—simple and compound—vary greatly over a long period of time. Compound interest loans pose the most problems because by the time you get your head around how they work, you are more in debt than you would’ve been under the simple interest formula.
A compound interest loan adds the interest amount to the principal (balance) every time it is compounded. The frequency which this happens may be yearly, semiyearly or monthly depending on your borrowing terms. After being compounded, the new balance is then subject to the interest rate, rapidly increasing the amount of debt owed. For example, let’s say you owe $20,000 to your lender. The interest rate is 6.8%, which is compounded yearly. Your goal is to pay off the debt in ten years. At the end of a decade, you will end up shelling out $38,613.80. Under the rules of simple interest, on the other hand, the interest rate only applies to the initial balance. So after 10 years, if the balance and interest rate are the same as above, you will owe $33,600, nearly $6,000 less than compounding.
If stretched out to 20 years, the gap gets considerably wider. Compounding turns a $20,000 loan into a $74,551.28 debt. Compare that to the $47,200 paid on the same loan based on simple interest terms.
The best strategy for beating compounding interest student loans is to get the principal amount down quickly. This will lessen the amount of interest added when it’s time for the loan to compound. The longer a loan is drawn out, the more money that goes in the pocket of your lender. There’s a reason why Sallie Mae’s vice chairman and chief financial officer Jack Remondi made $13.3 million in 2008.
Remember, student loans are arguably the hardest type of debt to get rid of and even after bankruptcy they remain on your credit report. Defaulting on your student loans can severely impact your credit score, which in term will increase the interest you pay on everything from a car, to a house, to that Playstation 4 you’ll want to put on your Best Buy card in eight years.
The frequency that the lender compounds your interest varies, check with them to find out what terms you are obligated to.
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