If you’ve taken a private, federal, or conventional loan, only to pay a sky-high amount of interest, then you are not alone. Different lenders follow different strategies for issuing loans and also in determining rates. Ideally, your loan balance decreases coupled with each payment we make towards clearing our loan. However, your total loan balance might increase due to missing payments, making payments after the due date, high credit card balances, periods of deferment, high debt-to-income ratio, and more. As the interests accrue, the principal amount that is due also increases causing the total loan amount to go up. Keeping such things in mind, we have collated a guide that will help you understand the different principles of loans and also how to pay them off without increasing your loan balance.
Capitalization
The term capitalization has different meanings but, in our context, it refers to unpaid or accrued interests that have been added to the principal. If you take out a direct consolidation loan, switch to a different repayment plan, or default in making timely payments for a specific tenure, then the unpaid and accrued interest will add to the principal amount causing the total loan balance to go up. In the case of student loans, this happens due to a halt in required payments. The interest starts accruing immediately after for other loan options such as a credit card cash advance.
Interest
This is the rate charged by lenders for giving loans to businesses, individuals, or groups. Similarly, for investors, it is their earnings for parking some savings in different financial institutions. Let us take a look at the different types of interest and how each type differently impacts the total loan balance:
- Fixed interest doesn’t change from the time of taking a loan to its repayment date. These are taken over a short term and either from loan dealers or individuals. This is often preferred by people as the payment usually stays the same throughout the loan tenure.
- Variable interest is a fluctuating rate wherein the payment made by the borrower depends on the market value set by any lending institution or bank. Some people like taking a risk with a variable rate as it can help them save money.
- The prime rate is a special rate given by banks and other financial institutions to their preferred customers. The rate is lower than other types of interest.
- The annual Percentage Rate (APR) is specific to credit card companies and is calculated annually depending on the total cost of your loan. For computing APR, banks add the margin charged by the lender with the prime rate.
- Simple interest or regular interest is the rate charged by banks and other lenders for the entire loan term. This interest is calculated on the principal loan amount. The loan balance doesn’t change due to the interest, for example, in installment loans. Thus, if the simple interest for 2 years is 3%, then the interest amount is calculated by multiplying the principal with a 3% rate and further multiplying the product by 2 years.
- Compound interest adds the accrued interest amount with the principal before computing the interest for the upcoming repayment. This causes both the principal and interest to increase with time. Compounding interest is common with credit cards.
Reasons behind rising loan balance
Various factors come into play in increasing the loan balance. Read on to know more about these factors:
Delay in loan repayment
The biggest reason behind the increasing loan balance is the delay in paying back loans. Defaulters are punished by banks or lenders for making delays or non-repayment. These hefty penalties negatively affect your credit scores. You can take the example of a federal student loan where the pupil might take longer to pay off the loan than what was promised in the agreement. This delay can result in rising loan balances.
Going for an extended payment plan
An extended payment plan means smaller payments over a longer tenure so that you don’t feel pressurized by the loan repayment. Most borrowers can qualify for this plan as it is offered by all federal loans. On the flip side, it increases the total loan balance and you will end up paying more than what you would have on choosing a short repayment period. Thus, if you repay a $5000 loan within six months, then you will pay less than someone who takes the loan over a span of 5 years. Salaried people opt for the longer repayment plan as they have to pay a very small amount every month. A short repayment period can help you finish off early and pay less compared to the extended plan. You should weigh the available options and choose the payment plan prudently.
Paying less than the actual interest
Your loan balance will increase if you pay less than the requested amount. For example, if you are supposed to pay an interest of 5% and you pay just 2% on the first year, then the remaining 3% will be added to your principal amount. This is an important point to consider so that you can avoid accruing your loan’s principal amount balance which can otherwise impose a negative impact on your total repayment. Every loan has a minimum amount due and if you pay less than that, then you might be charged a fee that gets added to your loan balance.
Deferred or missed payment
Postponing or missing a payment can impact your total loan amount negatively. Banks don’t like taking risks and they will penalize you for missing a payment unless you have taken a student loan. If you took the loan against collateral security, then you might even lose the assets tied as security for the loan. The interest will keep accruing when you miss or defer payment to a later date and this will add to your principal amount for increasing your loan balance. A grace period is allowed with student loans, but the interest still accumulates during that time.
Errors
Sometimes algorithmic errors like applying the wrong interest rate, and not updating the principal balance cause the loan balance to rise. These computation errors occur due to confusion. If you ever experience such a thing, then it’s essential to talk to your lender at the earliest to check if miscalculations are affecting your balance. You can also seek the assistance of Credit monitoring services to dispute errors with your credit cards alongside monitoring your credit reports and accounts. They can help keep collection calls at bay by updating your balance information with your credit card issuer. You should make it a point to honor the payments on time to prevent such errors from happening in the first place.
Using your credit account
Your loan balance will increase on using credit cards or other types of revolving credit. The more you spend it, your monthly payment will shoot up proportionately. Given the compounding rate of interest, more interest is charged because of the higher balance.
Federal Income-Driven Plans
This type of repayment plan assists the borrower with repayment after considering their annual income. It is applicable for student loans and similar loans which consider the family size and income of the borrower. Since the repayment is lower in this kind of plan, it shoots up the loan balance. Consolidating these loans with a private loan lender will make you lose your rights under the federal loan program. Thus, borrowers are advised to maximize their federal loan options before opting for private loans. There are six types of income-driven repayment plans:
- Standard Repayment Plan: You need to make fixed payments with standard loans for up to 10 years and consolidation loans between 10 and 30 years.
- PAYE Plan (Pay as You Earn Plan): 10% of your discretionary income will be charged in the pay-as-you-earn plan but it won’t exceed the standard repayment plan minimum.
- Income Contingent Repayment Plan (IRC): Your monthly interest obligation with ICR will be the lower value of 20% of your discretionary income or the amount due on a 12-year repayment plan depending on your current income. If any student loan balance is left over after 25 years, then it will be forgiven.
- Revised Pay as You Earn Plan (REPAYE): Repayment in this plan will be similar to the PAYE plan apart from payments that are recalculated every year depending on your family size and income. If you haven’t repaid your loan in 20 or 25 years, then the loan might be forgiven. This includes unpaid and accrued interest. Though you will ultimately pay more over time compared to a standard or PAYE plan, your student loan payments will be more manageable.
- Income-Based Repayment Plan (IBR): Also known as income-driven repayment plans, these will take your discretionary income into account for computing the monthly loan obligation. However, this won’t exceed 10-15% of the income. They also won’t exceed the 10-year standard repayment plan. Family size and income are considered for recalculating the payments every year.
- Income-Sensitive Repayment Plan: Federal student loan borrowers will have 15 years for loan repayment if they opt for an income-sensitive repayment plan. The monthly payments will be determined after considering the income. Your total student loan balance might increase if you change your repayment plan.
What makes different loan balances increase?
If you wish to avoid getting burdened with additional debt, then it’s important to know about the different scenarios which can add to your loan balance.
Mortgage loans
Making payments that are less than your monthly interest will increase your loan balance. Some other reasons are listed below:
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- Property tax alterations – Property tax is an important part of the monthly loan payment despite not being included in the loan amount. These tax rates can hike causing the ultimate interest rate to increase and making your total mortgage loan balance higher. Each country in the United States has its property tax rate which might either be higher or lower than the state average.
- Closing cost – The mortgage closing costs range between 2-6% of the total loan cost. This might heighten your total mortgage loan balance significantly more than your borrowing requirement. Different fees charged by the lender like origination, processing, insurance, appraisal, and underwriting are included in the closing costs. You can save big over the tenure of your home loan with a mortgage refinance if your credit score has improved or interest rates have dropped.
Auto loans
Your loan amount might boomerang due to the following factors:
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- Deferred payments – Late fees might be imposed on your amount due if you miss a car payment. These fees range between $25-$50 and can increase the total balance of your auto loan.
- Trading in a car having negative equity – Your new car loan balance might be higher than expected if you roll the old car loan into it. On trading an old car with negative equity, your dealership will offer a rollover into the new car loan. It’s advisable to consider an auto loan refinance if you wish to lower your monthly payments or save money on interest.
Student Loan Interest
Just like any other loan, student loans also come with a specific set of terms and conditions to which you must adhere to. Interest is charged on both federal and private student loans which have to be repaid post-graduation. Borrowers of federal student loans are either subsidized or unsubsidized. In the first case, the federal government takes all responsibility for paying the interest during your study period. The government will stop paying on your behalf once you graduate and you will have to take complete responsibility for loan payments. Since 2010, graduate and professional students are no longer eligible to get subsidized loans. In the case of unsubsidized loans, the interest starts accruing from the date of taking the loan but the payment obligation arises post-graduation.
Ways to reduce interest on student loans:
- Borrowing less money by searching for other avenues to pay for college can limit your payment obligation. Some options are getting a scholarship, working a part-time job, and also seeking assistance from friends and family.
- Refinancing is the best way to reduce your student loan debt. Here a new loan is taken to pay off your old one. As a result, you will have one monthly payment obligation rather than multiple payments. You can contact different lenders and ask about their rates, qualification criteria, and fees for eligible loans. This will lower your interest on your outstanding balance compared to what you would have paid on a federal student loan. The interest rates are determined after considering factors like your credit mix. Thus, a cosigner might be required to get you more favorable loan terms. However, refinancing federal loans might cause you to lose thousands of dollars in federal benefits like interest subsidies, PSLF, forbearance, and deferment. Refinancing doesn’t always guarantee a lower rate of interest and you should use this option only if you aren’t able to get into federal forgiveness programs.
- Signing up for autopay is another great means of reducing your interest payment obligations. A 0.25% interest discount is offered by federal loan and private lenders to borrowers who sign up to get their monthly loan payments automated. Companies like Verizon and Nelnet offer incentives to customers on setting up automatic recurring payments.
- Student loan servicers often provide loyalty discounts once you comply with some conditions like paying on time for a stipulated period or having an existing relationship with the credit union or bank. These can guarantee you a lower interest rate to reduce your overall commitments.
- A shorter repayment term will mean higher monthly payments but will limit the amount of accumulated interest. As a result, you will be able to pay off your debt faster. A longer-term repayment, on the other hand, accumulates more interest charges over time. You should opt for the option which works best for your financial situation.
- Last but not least, you can always negotiate with your lender for better terms like getting a flexible repayment plan. If you are successful, you might end up with an agreement where you will have to pay lower interest than your previous terms.
Checking your student loan balance
You can visit the Federal Student Aid website to check all information on your deferral student loan debt such as how much interest has been charged to date and how much has been paid toward the loan. You just need to create an FSA ID.
What happens if you don’t pay your student loans?
You will go into default and this can damage your creditworthiness. It will become difficult for you to get a loan in the future and also cause wage garnishment.
Ways to reduce the total loan balance
Pay on time
Late payments might attract penalties and this increases the loan balance. If you are trying to reduce the principal loan amount, then you can make extra payments. This will affect the interest you pay subsequently. You will ultimately end up paying less than what you would have had by sticking to your repayment schedule. The extra payments will help you pay off the entire loan obligation on time and increase your credit limit due to a good credit score. You can also utilize the extra funds to pay off your credit card bills which also helps increase your credit score by lowering the credit inquiries.
Pay more than what is due
It’s practical to pay more monthly than the minimum amount due if you want to decrease your loan balance. This also helps bring down the loan balance faster.
Search for a lower interest rate
How much you repay ultimately depends on the type of loan you choose. Different lenders follow different policies and have different conditions on loan interest. While the rates charged by some are higher, it’s lower for others. If you aim to reduce your loan balance, then you must take out a loan from a lender offering a low-interest rate.
Pay back the expensive loans first
High interest is charged on expensive loans. If you have taken loans from different lenders, then you should pay off the expensive ones first. If you default on paying off these exorbitant interests on time, then it will accrue faster and add back to the principal amount thus making it difficult to honor future obligations in time.
Get a temporary interest rate cut down
When offering a temporary interest rate reduction, the working mechanisms of private and federal student loan lenders are considerably different. For private loans, you can negotiate with the lender for a temporary interest reduction during times of financial hardship when you think you cannot repay the amount. The only option for a federal loan is to extend your repayment period according to your income so that the repayment is spread over an extended period and attracts lower monthly payment obligations.
Consolidate or refinance existing loans
Refinance is for one loan whereas debt consolidation is for paying off multiple loans. Under this process, you can take a new loan for paying off your existing debt. The interest rate of the new loan will be lower making repayment more manageable.
Consider a debt repayment strategy
You can try out the common methods listed below to speed up repayment:
- Reaching your money goals becomes easier with the budgeting tool. This holds especially true if you are trying to prioritize debt payments.
- Under the avalanche method, your highest-interest debt is prioritized while making minimum payments on your remaining debts. After paying off your highest-interest debt, you can move over to the second-highest one and so forth.
- The snowball method involves first paying off your highest loan balance while honoring the minimum payments on other debts.
Conclusion
A lot of borrowers complain that their loan balance has gone up even when they made regular payments. This can be both frustrating and disheartening if you find that your efforts aren’t paying off. But now that you have understood the entire concept, you can prevent your loan balance from getting higher by making on-time payments. This will also help you get free from the loan obligation. If you have a good payment history, then this shall reflect in a good credit rating which will help you in getting better loan terms if you plan on taking another.
