Student Loan Mistakes that Could Make Interest Soar
If you’ve taken out student loans to invest in your education, you know that paying interest on those loans is simply part of the deal. But while “interest” can seem like an abstract notion when you first take out loans, over time it can become a force to be reckoned with—particularly for the many MBA, law, and med school grads with six figures worth of education debt to repay.
For example, using a student loan calculator to get a rough estimate, you can see that a borrower with $100K in student loan principal at a 6.8% weighted average interest rate and a 10-year term can expect to pay an estimated $38K in interest over the life of the loan. And that’s if they make every payment on time.
Paying interest on student loans may be unavoidable, but there are a few mistakes that can cause some borrowers to pay more interest than they need to. Read on for tips on how to help prevent these blunders from affecting your bottom line.
Mistake #1: Using Forbearance When It Isn’t Absolutely Necessary
Most federal loans and some private loans may allow borrowers to use forbearance to temporarily reduce or suspend loan payments in the event of qualifying financial or medical difficulties.
But in most cases interest continues to accrue while payments are on pause—which means that the longer borrowers remain in forbearance, the more they may have to pay in the long run. (See Mistake #5 below.)
So if the goal is to minimize interest expenses, forbearance is typically an option best reserved for extreme financial hardship. Resuming regular payments as quickly as possible could be another way to minimize accrued interest.
If the borrower has federal student loans, enrolling in an income-driven repayment plan might be another option to consider. The monthly payment for an income-driven repayment plan is based on the borrower’s discretionary income and family size.
In certain cases (qualifying unemployment or the inability to work because of an illness, for example) payments could be as low as $0. After the period of financial hardship has passed, the borrower re-certifies the loan using new income information. (Recertification is required every year.)
Mistake #2: Unnecessarily Extending the Repayment Period
Federal student loan consolidation with a Direct Consolidation Loan allows borrowers to combine two or more eligible federal loans into just one loan, helping to streamline their monthly bills.
When borrowers consolidate, they’re typically given the option to lower their monthly payment by extending their repayment period. (With federal loan consolidation, the new interest rate is the weighted average of the borrower’s existing loans, rounded up to the nearest one-eighth of a percent. So extending the repayment period is the only way to lower the payment.)
For those who are struggling to make payments, that may be tempting. However, those smaller monthly bills can come at a price. Extending the payment term from 10 to 30 years, for example, would mean the borrower has to pay considerably more interest over the life of the loan. (Because the borrower would be accruing 20 additional years of interest.)
Mistake #3: Not Prepaying When Possible
All education loans, whether federal or private, allow for penalty-free “prepayment,” which means borrowers can pay more than the minimum required and pay off their loan balance early, without incurring any extra fees. Even paying an extra $100 per month could go a long way.
Whether it’s increasing monthly payments after receiving a raise or putting half of a bonus toward student loans each year, every little bit helps to drive down total interest.
Student loans are amortized, which means a portion of each payment is applied to the principal each month and a portion goes toward interest.
Early on, a larger portion typically goes toward interest, so the principal balance goes down pretty slowly. Usually, it isn’t until the borrower has made years of payments that a noticeable amount starts being applied toward the principal. One way to speed up that progress—and knock down the debt faster—is to pay more than is required each month.
(Borrowers should be sure to tell their lender what they’re doing and verify that their prepayments will be applied to their loan principal.) Borrowers can use this calculator to see how prepayment could help them get out of student loan debt sooner.
Mistake #4: Starting Accelerated Repayment Efforts with the Wrong Student Loan
Borrowers who have more than one student loan may choose to make extra payments on one loan at a time. It can be tempting to start on the loan with the smallest balance, put extra payments toward it while making timely minimum payments on other loans, get the emotional boost from eliminating that bill, and then move on to the next.
This approach is sometimes referred to as the “snowball method,” and it can be useful for borrowers who need the gratification of a faster payoff to stay motivated. But it might not save the most interest.
Prioritizing the loan with the highest interest rate (the “avalanche method”) can make more sense mathematically and might be more efficient for those who have the discipline to stick with it. And borrowers still can be excited as they watch the balance on that high-interest student loan go down.
There are a few online calculators that could be used to compare the avalanche method to the snowball method . Comparing the estimated interest payments and debt free dates could help borrowers determine which method will work best for them.
Mistake #5: Underestimating the Impact of Interest Capitalization
Deferment and forbearance periods may feel like a helpful option to escape making federal student loan payments when a borrower is struggling financially. But taking a break can be tricky.
The federal government will pay the interest on subsidized loans during deferment periods, but it won’t pay the interest on unsubsidized loans during deferment or on any loans during forbearance.
Unpaid interest also may accrue if a borrower is repaying federal student loans under an income-driven repayment plan and the monthly payment is less than the amount of interest that accrues between payments.
If a borrower doesn’t pay the interest as it accrues, that interest can be capitalized, or added back onto the principal balance of the loan. And any interest payments made after that will be calculated based on this new balance.
Interest also can capitalize when a student loan enters default, or when the six-month grace period ends. So, if it’s at all possible, borrowers who choose to press pause on their loans may want to try to make interest-only payments during that time.
Mistake #6: Failing to Claim the Student Loan Interest Deduction
OK, technically, this isn’t a way to save money on interest. But it can help alleviate some pressure for borrowers with qualifying student loan debt, since this student loan interest deduction can potentially reduce the amount of income that is subject to tax. (Reminder: Taxes can be tricky, and we are not here to provide tax advice. This is just a high-level look at a potential tax deduction, and isn’t a definitive accounting of the information available. Always consult with a tax professional about tax deductions and any questions around them.)
Borrowers may be able to deduct up to $2,500 on federal and student loans on their federal return each year. That’s $2,500 per return, so those who are married and file a joint return have the same $2,500 cap even if both spouses have student debt.
The deduction begins to decrease at a certain income threshold, depending on the taxpayer’s filing status. For the 2019 tax year, the deduction starts to phase out at a modified adjusted gross income (MAGI) above $70,000 for single and head of household filers, and it’s eliminated entirely at a MAGI above $85,000.
For those who are married filing jointly, the phase-out starts at a MAGI above $140,000 MAGI and is eliminated for those with a MAGI above $170,000.
For a student loan to qualify under the IRS’s rules , it must have been obtained with the sole purpose of paying for qualified education expenses for the taxpayer, the taxpayer’s spouse, or someone who was the taxpayer’s dependent at the time he or she took out the loan.
The person for whom the loan was taken must have been enrolled at least half-time in a program that leads to a degree, certificate, or other credential. The loan can’t have been from a relative. Qualified education expenses can include things like tuition, books, supplies, equipment, and, in some cases, room and board.
Because this deduction is claimed as an adjustment to income, taxpayers don’t have to itemize to take it, but it does require proper documentation. If the loans are officially referred to as student loans—whether they’re federal or private student loans—the lender would send a Form 1098-E, Student Loan Interest Statement. Borrowers can claim the interest from some other types of loans but will have to track those amounts on their own.
Again, taxes can be tricky, so definitely consult with a licensed accountant or tax professional to get the low-down on all the details of this or any other tax deduction.
Mistake #7: Not Signing Up for Autopay
With automatic payments, student loan payments are transferred directly from a borrower’s bank account to the lender, which reduces the chances of a late payment and gives the borrower one less thing to worry about.
There’s often another important perk: Some lenders will reduce the interest rate on the student loan by a certain percentage.
For those who keep enough funds in their account to cover their bills every month, it’s another potential way to save. And if the situation changes, and a manual approach becomes necessary, a borrower should be able to stop automatic payments at any time.
Borrowers who like the idea of making extra payments could set up their autopay to make a half payment every two weeks, or 26 half payments each year. That option adds up to 13 full payments instead of 12—or one extra payment. (This can be done manually, as well—it’s just that autopay typically makes it easier.)
Mistake #8: Making Late Payments or Going into Default
Failing to make payments can have several negative repercussions, including legal consequences if the borrower defaults on the loan. Both delinquency and default can also negatively impact the borrower’s credit score.
A lower credit score may reduce a borrower’s chances of getting a competitive interest rate on a refinancing loan, or on other types of loans or credit cards in the future.
Mistake #9: Neglecting to Explore Refinancing Options
Another opportunity that could allow borrowers to stick it to student loan interest is to refinance student loans at a lower interest rate and, possibly, a shorter repayment term. And some lenders, including SoFi, offer both variable and fixed rate loans, so borrowers can choose what best suits their needs.
Refinancing can typically be an attractive option to borrowers who have a solid financial situation—for example, a comfortable debt-to-income ratio (among many other possible considerations). However, before refinancing federal student loans, borrowers should check to see if they qualify for any forgiveness programs or other federal benefits (like income-driven repayment plans) and other repayment options that are forfeited when refinancing federal student loans with a private lender.
Bottom line: Refinancing to a shorter term with a lower interest rate can help eligible borrowers take a big bite out of total interest.
Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.
External Websites: The information and analysis provided through hyperlinks to third-party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.
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SoFi Student Loan Refinance
If you are a federal student loan borrower, you should consider all of your repayment opportunities including the opportunity to refinance your student loan debt at a lower APR or to extend your term to achieve a lower monthly payment. Please note that once you refinance federal student loans you will no longer be eligible for current or future flexible payment options available to federal loan borrowers, including but not limited to income-based repayment plans or extended repayment plans.
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