WorkForTime
Simply explained

How do student loans work?

The fundamentals of student loans and how you can save thousands of dollars in unnecessary payments.


With debt totaling $1.5 trillion dollars in America, there is no denying that we are in a student loan crisis — which continues to grow as more students choose the burden of riskier loans for more expensive degrees. While many are hoping for their debts to be forgiven, part of the problem lies in not understanding just how loans work in the first place.

The reality is that student loans are not just big bills or IOU's to pay later; they are financial instruments built on a clever formula. If you do not understand this formula, the debt can overwhelm you for years. However, if you know how it works and take care to follow the rules, you can seize control of your education and your financial future!

Student Loan Fundamentals

A student loan has three parts:

  1. Principal - the amount you borrow
  2. Term length - how long it will take you to pay back
  3. Interest rate (more on this next)

For example, you borrow $10,000 at a 6% interest rate,
paid back over 10 years. These 3 numbers will determine your monthly payment (and how much extra you'll pay).

Principal

$10,000

Term Length

10 years

Interest Rate

6%

You pay it back monthly, plus a daily fee.

Every day, interest is added to your total in the form of a daily fee*. You can think of this as "rent" on the money you borrowed. The more you borrow and the higher your interest rate, the greater your daily fee will be.

Every monthly payment must first pay off the interest.
You have to pay your "rent" first every month. Whatever is left over is used to pay down some of what you borrowed (and reduces your daily fee ever-so-slightly next month).

* subsidized federal loans won't accrue interest while you're in school
* student loans use simple interest, not compound interest
Total Interest This Month

$1.67

Daily Fee

$1.66

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Days Since Last Payment

How much interest?

Your student loan has an annual interest rate. We can get the daily interest rate by dividing by 365 days, or the monthly interest rate by dividing by 12 months*.

Multiply this rate by your principal (what you still owe) and you have the interest you owe that month.

Monthly
Interest
=
Interest Rate
12
×
Remaining
principal
* exact numbers may depend on how many days there are in that month
Monthly Interest Calculator
Principal
$
Interest Rate (APR)
%

Monthly Interest Rate (6% ÷ 12)

0.500%

Principal

× $10,000.00

Interest (month 1)

$
0
Example

Let's look at month one.

Based on these numbers ($10,000 @ 6% interest), in the first month you will have accumulated $50.00 in interest.

So if your monthly loan payment is $110, then $50.00 goes to paying this month's accrued interest. Then the remaining $60.00 goes to paying down your loan.

As you pay down your loan, your monthly interest will get smaller and smaller because you'll be borrowing less and less. Put another way, the less money you borrow, the less rent you pay to borrow that money.

Monthly Payment
$

Monthly Interest

-$50.00

Remaining Loan Repayment

$60.00

Initial Balance

$10,000.00

-$60.00

New Balance

$
0

The Payment Schedule

All of the future payments can be calculated in advance and are listed below in what is called an Amortization Schedule. Do you see the pattern?

PrincipalInterest RateMonthly PaymentDurationTotal InterestTotal Paid
$10,0006%$11010.2 yrs$3,368$13,368
Principal$10,000
Interest Rate6%
Monthly Payment$110
Duration10.2 yrs
Total Interest$3,368
Total Paid$13,368
Month
Payment
Interest
To Principal
Total Interest
Balance
0
--
--
--
--
$10,000.00
1
$110.00
$50.00
$60.00
$50.00
$9,940.00
2
$110.00
$49.70
$60.30
$99.70
$9,879.70
3
$110.00
$49.40
$60.60
$149.10
$9,819.10
4
$110.00
$49.10
$60.90
$198.19
$9,758.19
5
$110.00
$48.79
$61.21
$246.98
$9,696.98
6
$110.00
$48.48
$61.52
$295.47
$9,635.47
7
$110.00
$48.18
$61.82
$343.65
$9,573.65
8
$110.00
$47.87
$62.13
$391.52
$9,511.52
1

The colorful chart above shows what percentage of each monthly payment goes towards interest and your principal respectively. Notice how you pay the most interest in your early payments.

Student Loan Misconceptions

While this formula is relatively simple, the complexity comes from the interaction of the principal, the interest rate, and the monthly payment.

Key Insight #1

Interest grows exponentially as you borrow more.

Once you've started taking out loans, it's easy to take out more as you need them. Especially for additional years of school. For example, say you take out this loan here for $10,000 with a $200 monthly payment.

It actually looks pretty reasonable. At 6% interest, you'll end up paying about $1,511 in interest and it'll take just under 5 years to pay off. You'll pay $11,511 to borrow $10,000.

Principal
$10,000
Interest Rate
6%
Mo. Payment
$200
Interest
$1,536
Duration
4y 10m
Total Paid
$11,536

But what happens if you decide to take out $20,000?

If you keep your monthly payment the same, will it take twice as long to pay off? Are twice the loans twice as bad? Worse. It'll take almost 3 times as long with over 5 times the total interest paid! $1,511 becomes $7,627 in interest!


Total Paid vs Total Borrowed (Principal)
Total Paid

$27,795

To borrow

$20,000

$10,000$11,536Underwater$20,000$27,795$0$10,000$20,000$30,000$40,000$20,000$40,000$60,000$80,000$100,000$120,000
PrincipalInterest RateMonthly PaymentDurationTotal InterestTotal Paid
$20,0006%$20011.6 yrs$7,795$27,795
Principal$20,000
Interest Rate6%
Monthly Payment$200
Duration11.6 yrs
Total Interest$7,795
Total Paid$27,795

And it gets worse. What if we went up to $30,000?

Drag the slider above to find out.

Rather than taking 3 times as long it will take almost 5 times as long, and you'll pay a whopping $24,723 in interest.

Unfortunately, high principals and low monthly payments is a very common situation. The people with the least ability to pay have to pay the most.

Key Insight #2

Lower monthly payments exponentially increase your interest.

Unfortunately, when borrowers get low on funds they try to lower their monthly payments to ease the burden of their bills. They think "my loans will just take longer to pay off".

However, lowering your monthly payment will result in exponentially more profit (interest) for the bank. You've eased your bills today only to pay much more over the lifetime of your loan.


Total Paid vs Monthly Payment
Total Paid

$55,590

To borrow

$30,000

Underwater$55,590$0$50$100$150$200$250$300$350$400$450$20,000$40,000$60,000$80,000$100,000$120,000
PrincipalInterest RateMonthly PaymentDurationTotal InterestTotal Paid
$30,0006%$20023.2 yrs$25,590$55,590
Principal$30,000
Interest Rate6%
Monthly Payment$200
Duration23.2 yrs
Total Interest$25,590
Total Paid$55,590

But the reverse is true too.

If you increase your monthly payment, even just a little, you will pay less in interest over the lifetime of the loan. You'll pay it off faster and spend less overall.

Many borrowers are reluctant to increase their monthly payment because it definitely doesn't feel like saving money. It feels more like you've increased your bills when in reality you're saving money for your future self.

Key Insight #3

Higher interest rates exponentially increase your total interest.

You're probably seeing the pattern here. While federal loans all have fixed interest rates, private loan interest rates will differ person-to-person.

Based on your credit score, the bank determines how risky they think you are to lend to. If you don't have strong credit (which very few high schoolers do) they'll give you a higher interest rate. That one little number can have you paying exponentially more for the same education.


Total Paid vs Interest Rate
Total Paid

$55,590

To borrow

$30,000

Underwater$55,5900%1%2%3%4%5%6%7%8%9%10%11%12%$20,000$40,000$60,000$80,000$100,000$120,000
PrincipalInterest RateMonthly PaymentDurationTotal InterestTotal Paid
$30,0006%$20023.2 yrs$25,590$55,590
Principal$30,000
Interest Rate6%
Monthly Payment$200
Duration23.2 yrs
Total Interest$25,590
Total Paid$55,590

The good news here is that if you make all of your payments, improve your credit, and start earning money after college, you can lower your private loan interest rates in the future. This is called refinancing.

The reason banks can offer you a lower interest rate is that you have proven that you're a reliable borrower capable of making your payments. Less risk means less interest.

Key Insight #4

Combining exponentially bad terms is exponentially worse.

Of the three situations we've described...

  • high principal
  • low monthly payment
  • high interest rate

...having just one is not that bad, and is often necessary to put yourself through college. Having two of them is difficult, but doable.

However, having all three is a recipe to bury yourself in debt and be stuck paying it for decades.

Use the sliders below to see how all three work together. When you cross the "underwater" line that means you're not paying enough to even cover your interest. This means your loan never decreases.


Total Paid vs Total Borrowed (Principal)
Total Paid

$88,944

To borrow

$30,000

Underwater$30,000$88,944$0$10,000$20,000$30,000$40,000$20,000$40,000$60,000$80,000$100,000$120,000
PrincipalInterest RateMonthly PaymentDurationTotal InterestTotal Paid
$30,0006%$16046.3 yrs$58,944$88,944
Principal$30,000
Interest Rate6%
Monthly Payment$160
Duration46.3 yrs
Total Interest$58,944
Total Paid$88,944
1

If you're interested in finance articles like this one, I'm writing more on building wealth after student loans. It's all free and covers what I think should be required knowledge for building a strong foundation for investing and retirement. You can check it out here.

How can I avoid unmanageable student loan debt?


Student loans as a last resort

The best way to avoid being buried in debt is to avoid student loans in the first place. This is obviously not an option for everyone (62% of students in the U.S. graduated with student loan debt). However, you should exhaust all other options before taking out loans:

  • college savings
  • grants and scholarships (a.k.a free money)
  • federal subsidized loans
  • federal unsubsidized loans
  • private loans (as a last resort)

Your education is a financial investment

A common mistake is to choose our schools and degrees based on our societal ideologies. We tout ideals like:

  • you should always follow your passion
  • everyone should have the same access to education
  • attend your dream school at any cost
  • low-paying careers (teachers, arts & literature, etc.) are just as valuable as higher-paying ones (engineering, doctors, etc.)

Schools perpetuate these ideas by allowing you to study "whatever you desire" once you've been accepted.

While these are excellent goals to strive for, financially, they do not reflect reality, and they should not be used to ignore the fact that college can be prohibitively expensive.

Those who borrow have fewer options and opportunities, and if the only way to "succeed" is to bury yourself in insurmountable debt, then it wasn't an option in the first place.

You need to choose a degree that you enjoy and can afford. More specifically, if you have to take out a lot of debt in order to pay for your degree, you should consider a field with higher earning potential (and research the average starting salaries of your chosen degree from your school).

Not all degrees cost the same

Take two students attending the same school, both with student loans, where one majors in Teaching while the other chooses Computer Science. Does it make sense for these degrees to cost the same?

Well they don't. With a lower earning potential, not only will the Teacher be paid less in his/her career, but the degree could cost twice as much (assuming it'll take longer to pay off the loans).

Students with large loans who...

  • choose low-earning professions
  • take longer to pay off their loans
  • or have poor credit (higher interest payments)

... will pay more for the same education. You can think of student loans as a multiplier on the cost of your education. The table below shows how much more you pay given your loan terms.


Total Paid Multiples Based on Interest Rate and Term Length
2%4%6%8%10%12%
5 years1.05×1.10×1.16×1.21×1.27×1.33×
10 years1.10×1.21×1.33×1.45×1.58×1.71×
15 years1.16×1.33×1.51×1.71×1.92×2.14×
20 years1.21×1.45×1.71×1.99×2.29×2.62×
25 years1.27×1.57×1.92×2.29×2.70×3.12×
30 years1.33×1.71×2.14×2.61×3.12×3.66×

How to Accelerate Your Student Loan Debt Payoff

Make additional payments.

If you want to pay less interest over the lifetime of your loans, consider making additional payments. This not only pays down your loan faster, but reduces the interest on all of your future payments. With most student loans you can do this online at any time.

You can use the calculator here to see how much you can save. The more you can safely contribute, the less interest you're paying to the bank unnecessarily. Don't you want to pay the bank less money?

Note: Make sure to only contribute what you can (i.e. not your emergency fund or money needed for upcoming bills). Finally, make sure your bank knows that you want it to go towards the princpal and not future payments.

Extra Payment Calculator
Current Principal
$
Interest Rate
%
Monthly Payment
$
Additional Payment
$

$
0

Reduced Total Interest

Target your loans with the highest interest rates first.

Some people like to tackle their loans with the smallest principal first because they feel accomplished when they've paid off a loan. Others want to tackle the largest loan first to get it out of the way and then the rest will be "easier".

The reality is, you should always pay down whichever loan has the highest interest rate to save the most money.

It doesn't matter how much the principal is on your loans. Paying down as much of your highest interest rate loan as possible (and then just the minimum on all others) will result in the most savings.


Total Interest Paid

$
0

Sort By
Largest
Interest Rate
Largest
Principal
Smallest
Principal
1
2
3
4
Interest Rate
11%
Principal
$3,200
Interest Rate
7%
Principal
$5,000
Interest Rate
4%
Principal
$1,600
Interest Rate
3%
Principal
$20,000

Refinance for a lower interest rate.

If you haven't missed any of your payments, your income has increased, or your credit score has improved since the time you took out your student loans you should seriously look at refinancing.

The way refinancing works is that you take out a new loan with another bank to pay off your existing loans, at a lower interest rate.

The new bank can offer you a lower interest rate because you have become less of a financial risk. With a proven track record of making payments, and a well-paying job, you are a more reliable candidate for borrowing.

If you're unsure whether this is worth it, consider that applying for refinancing will take on the order of hours to save you potentially thousands of dollars. Are you earning thousands of dollars an hour at your current job? If not, the return on investment is potentially unmatched.

Reference Tool

Student Loan Calculator

Loan Balance
$
Interest Rate
%
Monthly Payment
$
/ mo
Paid Off In

7y 5m

Total Interest

$6,539

Total Paid

$26,539

1
Month
Payment
Interest
To Principal
Total Interest
Balance
0
--
--
--
--
$20,000.00
1
$300.00
$133.33
$166.67
$133.33
$19,833.33
2
$300.00
$132.22
$167.78
$265.56
$19,665.56
3
$300.00
$131.10
$168.90
$396.66
$19,496.66
4
$300.00
$129.98
$170.02
$526.64
$19,326.64
5
$300.00
$128.84
$171.16
$655.48
$19,155.48
6
$300.00
$127.70
$172.30
$783.18
$18,983.18
7
$300.00
$126.55
$173.45
$909.74
$18,809.74
8
$300.00
$125.40
$174.60
$1,035.14
$18,635.14