Loans play a significant role in the lives of many Americans, providing essential financial support in times of need. However, it is important to understand that loans can have unexpected consequences if not managed properly.
One type of loan that often surprises borrowers is student loans. While repayment typically begins after leaving school, the loan amount starts accruing interest from the moment it is received.
As a result, borrowers may be shocked to discover that their loan balance has increased over time.
In this article, we will explore the factors that contribute to the growth of your total loan balance and shed light on this often overlooked issue in the United States.
How to understand your loan balance
When you borrow money, you usually have to pay back more than what you borrowed. This is because lenders charge interest on top of the loan amount.
To understand why the total cost of a loan can increase, it’s helpful to know a few key concepts:
- Principal amount: This is the initial amount of money you borrowed.
- Interest rate: The fee charged by the lender for borrowing the money.
- Annual percentage rate (APR): This includes the total cost of borrowing, including interest, fees, and other charges.
- Fees: These are additional charges related to the loan, such as origination fees or payment processing fees.
- Loan balance: The remaining amount you still owe to the lender.
By understanding these terms, you can better evaluate the factors that can cause your loan balance to increase.
Types of Interest
There are two main types of interest rates you should know about:
Fixed Interest Rates: These rates stay the same throughout the loan period. Most loans, like installment and personal loans, have fixed interest rates. Your payment remains consistent, but your loan balance can still change.
Variable Interest Rates: These rates can change during loan repayment based on various factors. With a variable rate, the interest can go up or down, and some people choose it to potentially save money.
The way interest is collected also affects your loan balance. There are two major methods:
Compounding Interest: This type of interest is calculated on the principal amount and any previously accumulated interest. It can cause your loan balance to increase over time, as seen with credit cards. It’s important to understand credit card interest rates and APRs to manage your expenses wisely.
Simple Interest: This is the most common type of interest calculation used in loans. With simple interest, interest is only calculated on the initial loan amount, not on previously accrued interest. The loan balance should not change solely due to the interest. Installment loans often follow this type of interest calculation.
Understanding how interest rates work is crucial because they can have a significant impact on your loan balance.
What Increases Your Total Loan balance?
A recent report by Forbes revealed that over half of the borrowers with student loans experience the challenge of a growing loan balance even after five years.
Here are the reasons why your loans continue to accumulate and grow:
Accruing Interest: Once your loan is disbursed, interest starts accumulating on the principal amount.
This means that even if you’re not making payments, the loan balance increases over time.
Capitalization: Unpaid interest can be added to the principal balance of your loan.
When this happens, you end up paying interest on a higher loan amount, leading to further growth of your debt.
Calculation errors: Lenders’ calculation errors can cause your loan balance to spike unexpectedly. It’s important to monitor your balance and keep records of your financial documents, statements, and transactions as evidence.
Deferment or Forbearance: If you postpone or temporarily pause your loan payments through deferment or forbearance, interest may still accrue during this period.
When the deferment or forbearance ends, the accumulated interest gets added to your loan balance.
Late or Missed Payments: Late or missed payments can result in additional fees and penalties. These charges can increase your loan balance and make it harder to pay off your debt.
Extended Repayment Terms: Opting for longer repayment terms may lower your monthly payments, but it can also lead to more interest being paid over the life of the loan, causing your overall balance to increase.
It’s important to understand these factors to make informed decisions about your student loans and take steps to manage and reduce your debt effectively.
Tips to Prevent Your Total Loan Balance From Increasing
By using effective strategies and staying consistent, you can keep your total loan amount from becoming overwhelming.
Pay a little extra: Pay a little extra with each installment, even if it’s just a few dollars. This can help prevent your loan balance from increasing. Make sure to inform your lender if you choose to make extra payments. You can also talk to them about allocating the extra payments towards higher-interest loans.
Setting up automatic payments: Consider setting up automatic payments, as this can lower the interest rates on your loans. Many financial institutions offer a small reduction in interest rates when you opt for automatic payments. This can help keep your total loan balance under control.
Paying off loans with high-interest rates: Focus on paying off loans with high-interest rates first, especially student loans. Student loans usually have high-interest rates, and they cannot be discharged through bankruptcy. For federal student loans, you may be eligible for a loan forgiveness program, but it is temporary, so it’s best to repay them as soon as possible.
Before taking out a loan, compare different lenders and choose one with lower interest rates. Only borrow the amount you truly need to avoid unnecessary debt.