Jon O'Donnell Updated on June 22, 2017

How To Avoid The Biggest Mistakes People Make With College Loan Payments

Formulating your college funding plan requires so many decisions, but it’s important to stay sharp while you’re attending to those final details.

The fact is, some of those seemingly small decisions you need to make — like selecting a repayment plan — could end up having a big impact on your financial future.

So today, let’s walk through what you need to know to avoid some of the biggest mistakes people make when setting up their student loan payments.

Three Things You Need To Know About Student Loan Repayment

Before we get into the nitty gritty of repayment plans, let’s review a few “golden rules” that should guide your decisions about payment plans:

  1. The faster you can pay off your loan, the cheaper your loan will be.
  2. Any kind of deferred (or delayed) payment option is likely to increase the size of your loan and your payments.
  3. Even though fast is good in terms of payoff, it’s not worth agreeing to an overly-aggressive payment schedule that could put you in default.

Let’s dig in to how these golden rules play out in the real world.

How Payments Work

Student loans consist of two different pots of money:

  1. the principal, which is the amount that you’re borrowing, and
  2. interest, which is how banks and lenders make money from issuing loans

It’s important to realize that for every day that you hold the loan — from the day the lender issues the first check — you will be charged interest. So the faster you pay off the loan, the fewer days you’ll be charged interest.

If you opt to make lower payments over a longer period of time, you’ll be charged interest longer. Result: you’ll pay a lot more in interest over the life of the loan — potentially thousands of dollars.

You can also wind up in a situation where interest snowballs and drives up the principal on your loan. This is called capitalization. We’ll discuss how this works in more detail below.

Why You Should Start Making Payments ASAP

When you’re selecting repayment plans, most lenders offer a variety of options. Some will allow you to select from different payment choices while you’re still in school.

The sooner you can get started paying off your loan, the better. Making payments of any kind while you’re in school will help save you a lot of money over the life of your loan.

Some lenders may allow you to start your payments after you have completed school. Some may even offer a grace period which will allow you to defer payments until six months or so after you’ve graduated.

While this may sound like a useful option so you can conserve cash while you’re in school, remember what we said above: deferments can be costly.

Why is that? Because your lender is still charging you interest during that time.

And here’s where deferments can be really problematic: unpaid interest can capitalize. Capitalizing is when unpaid interest is added to your loan’s principal amount. That costs you money in two ways:

  • your principal balance inflates to an amount that’s larger than the sum of money you originally borrowed, and
  • because interest is charged on the new, higher principal, you’ll effectively end up paying interest on interest.

That’s why you should only opt for deferment if there’s no way that you can make payments of any kind on your loan. Even partial payments may prevent interest from capitalizing.

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What Types Of Repayment Plans Are Available?

Let’s look at some typical repayment plan options.

Principal plus interest:
This is when you make a full payment every month. While you’re only making one payment, that money is applied to two places — you guessed it, the interest and the principal.

In any payment option, the interest always gets paid first. So if your payment is $150, the first $42 might be put toward the interest and the remaining $108 would be applied to your principal. Most lenders offer principal-plus-interest payments as an option while you’re still in school, although these kinds of payments may not be required until you’re out.

Interest only:
This is when you pay off your monthly interest every month but do not reduce your loan’s principal.

Remember, interest is how banks are compensated for holding loans. If you make interest-only payments, you’re paying the bank but you’re not reducing your overall debt.

Flat payments:
Some lenders allow borrowers to make what they call flat monthly payments, in which the borrower agrees to pay a certain amount every of money every month while still in school. However, these payments function the same as other payments. Money is first applied to interest and then to principal.

If you agree to pay an amount that is lower than your monthly interest, the unpaid interest can capitalize and increase the size of your principal. On the other hand, paying an amount that is higher than your monthly interest will allow you to start chipping away at your principal, even if you aren’t able to make full payments until later.

Here are some payment options that are offered by our lending partners.

What You Need To Know About Penalties And Fees

Remember our third “golden rule?” Be cautious about agreeing to overly aggressive payoff plans that you might not be able to keep up with. There are two reasons for this:

  1. If you get behind on payments, you may be charged penalties for late, missed, or partial payments. These charges can add up quickly and significantly increase your loan obligation.
  2. Once unpaid interest starts capitalizing, your principal can increase quickly and you’ll be paying interest on interest. These are the debt “black holes” that can be difficult to find your way out of, and they can have a lasting and negative impact on your credit far into the future.

The good news is that most reputable lenders will allow you to pay extra every month if you so choose. That money will be applied directly to the principal.

Admittedly, it can be tricky to know how much you’ll be able to afford in terms of payment several years down the road when you’re just starting college. Check out our free NitroScore tool to help you forecast loan payment affordability based on your choice of school and major.

Which Lenders Offer The Best Repayment Plans?

We maintain relationships with several highly-vetted lenders. We recommend checking out these trusted lending partners if you’re looking for a student loan.

Best Banks for Private Student Loans in 2017. Get Your Rate.

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