Your total loan balance can go up despite timely repayments due to several factors. A common culprit that increases your total loan balance is interest capitalization which is the time value of money. Let’s understand how loan repayments work and how can you reduce your total loan cost.
How to Lower Your Loan Balance
Looking at your inflated loan balance after years of repayment, if you are wondering what increases your total loan balance, then you are not alone. According to a report by Moody, over 49% of federal student loan borrowers owe more money than they borrowed five years after regular repayments. Let’s look at why interest is capitalized and how loan balances increase over time.
- Long-Term Loans – Borrowers with long-term repayment plans (more than ten years) may see their loan balance increase since the repayments are insufficient to cover the accrued interest.
- Adjustable Interest Rates – Variable interest rate loans are linked to indexes like the London Interbank Offered Rate (LIBOR) or Secured Overnight Financing Rate (SOFR). If the interest rate increases and you don’t increase your loan payments, your loan balance may go up.
- Income – Driven Repayment Plans- You can decrease your monthly loan payments to as low as zero during difficult times with an Income-Driven Repayment Plan. However, lenders will still charge you the interest during this time, increasing your loan balance.
- Forbearance/Deferment/Grace Period – Your loan balance may go up if you have availed of forbearance or deferment on your loan. Lenders may also charge interest during grace periods during which you are not required to make loan payments.
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How to Avoid Paying Capitalized Interest
Once you have understood how interest capitalization works, it’s time to know how to avoid paying capitalized interest. Here are some ways to reduce your total loan balance-
- Increase Your Loan Payments – You can make extra payments to your loan account to lower the accrued interest added to the principal amount. You can regularly pay more than your EMI or make a bulk payment at any time to reduce your overall principal amount. Make sure the lender does not charge a prepayment penalty for early repayments.
- Refinance/Consolidation – You can choose to refinance or consolidate multiple loans to a more suitable repayment program or a lower interest loan. A REPAYE Plan may forgive 50% of the accrued interest each month. Check the detailed loan repayment schedule and projected outstanding balance before signing the new loan document. One important factor that affects interest capitalization is the nature of compounding-whether it’s daily, weekly, monthly, or annually.
- Government Programs – Due to the COVID pandemic, the US government introduced various programs under the Coronavirus Aid, Relief, and Economic Security (CARES) Act and the American Rescue Plan Act to help borrowers with zero interest forbearance, emergency credit, debt consolidations, etc. If you have the resources, you can take this opportunity to reduce your total loan balance.
You can benefit financially from understanding how lenders charge you for a loan and what increases the total loan balance. Your total loan balance may increase in fixed-term loans for the first few years even if you make regular payments due to interest capitalization. Your loan may also accrue interest if you avail forbearance or miss payments. You can offset the effects of interest capitalization by making extra payments or refinancing your loan to more reasonable terms. You can also take help from government programs to lower your total loan balance.