This Formula Is Key To Understanding Student Loan Balances
A few days ago, while on Facebook, I saw a post on my newsfeed about their student loans, complete with pictures, which really illustrated a lot. One picture was their balance at the beginning of their loan repayment. The second picture was the current balance of their loans… roughly 4 years, no missed payments, and more than the minimums paid later. In that time, their overall balance had gone down by only $1,000 or so.
In my mind, I went “YIKES!”. My friend had been faithfully paying their loans and had barely made a dent in the balance. This person was absolutely doing their utmost to pay down their loans, to no avail. The post did yield some good advice as well as some great discussion on the nuances, or lack thereof, when it comes to the student loan crisis.
Factors Going Into Student Loan Monthly Payments
As to why that friend, and many others don’t seem to be able to pay down their balances, it all comes down to the following factors:
- The interest rate
- Amortization (how the payment is split between interest and principal)
- The monthly payment
The factors are all encapsulated in the following formula:
MIP = 30*B*[(IR/100)/365]
- MIP: Monthly Interest Payment
- B: Current Loan Balance
- IR: Annual Interest Rate (%)
- 30 days/month
- 365 days/year
This formula is part of why my friend has barely made a dent in their original balance… but it’s also a key to how they can begin to pay down their loans. Special note: this formula is for simple interest. Lord help you if the interest on your loans are compounding.
How, you ask? Well let’s begin to answer this with a very quick and dirty primer on loan repayment in general.
Student Loans & Amortization
Like all other installment loans, student loans are amortized, meaning that there is a repayment schedule over a defined period, where a portion of the monthly payment goes towards the interest, and the rest going towards principal. In the beginning of the repayment cycle, more of your monthly payment will be applied towards interest than to the principal. As time passes, the balance will start to go down and more of the monthly payment will go towards the principal, until the loan is paid off.
For example, if you had a monthly payment of $400, in the first years, $300 might go towards interest and $100 towards the principal. As time passes, more of that $400 will go towards the principal.
Simply put, loan amortization ensures that the lender will get the full interest charge from the borrower.
In many cases, especially with student loans, a really interesting and wicked thing happens, and it usually happens with high interest rate loans. The monthly payment might not even cover all of the interest charged for that month. What happens then is that the unpaid interest is added to the balance and interest is then charged on that, a process called capitalization (also known as “negative amortization”). THIS is why my friend’s balance has barely gone down. Their payments must not have covered all of the interest charged, and that interest capitalized.
Using The Formula To Your Advantage
How do you prevent capitalization? Well let’s get back to the formula:
MIP = 30*B*[(IR/100)/365]
This formula will help you estimate the amount of interest (MIP) that will be charged for that month. Knowing that will allow you to make any number of decisions, depending on your own personal situation. In a situation where MIP ≥ your monthly payment, you really have to take decisive action fast, though you do have options at your disposal. Let’s look at them:
- Option 1: Increase your monthly payments above the MIP. The more money you plow into your student loans, the faster you’ll lower the balance. Here’s a handy guide from Student Loan Hero on how to make extra payments, especially towards principal.
- Option 2: Refinance your loans. If you can get a lower interest rate and decrease your overall payment over the life of your loan, you’ll benefit greatly. A lower interest rate will work in your favor as the MIP will go down, which will free up a greater proportion of the monthly payment to go to the balance. Again, Student Loan Hero has a very easy and helpful guide on this!
Following either steps will help you better pay down your student loan balances and life the burden that comes with them. The first step in all of this is to know the amount of interest you’re being charged. Only then will you know what to do next.
Let me know your thoughts in the comments, especially if you have any stories about your student loans.
