Source: College Investor
How important are student loan interest rates when paying off student loans? How do interest rates affect loan payments?
The truth is, not much.
One of the most popular “alternatives” to flat student loan forgiveness is the argument that federal student loan interest rates should be set at 0%. But given the wide range of student loan forgiveness programs and other assistance available, do student loan interest rates really matter?
Let’s take a look at how interest rates affect your student loans.
Related: Find out how much your loan will cost with our free student loan calculator
please don’t double my rate
Back in 2006, Democrats included a pledge to cut student loan interest rates in half as part of their “Six for ’06” midterm campaign promise. When the time came to make good on this promise, they limited it to subsidizing federal Stafford loans for undergraduate students and phased in interest rate reductions. The interest rate will be lowered over four years from 6.8% to 6.0%, 5.6%, 4.5%, and finally to 3.4%.
This law was repealed in 2012, and the interest rate returned to 6.8%. This led to the “Don’t Double My Rate” campaign. After all, if student loan interest rates were a winning issue in one election, why not use that issue in another?
Some borrowers reacted to the prospect of doubling interest rates on new student loans, saying they couldn’t afford to double their student loan payments.
However, doubling your student loan interest rate does not mean your monthly student loan payments will double.
Doubling the interest rate on your federal student loans would only increase your loan payments by about 10 to 25 percent each month over a 10-year period. In this particular situation, if the interest rate increases from 3.4% to 6.8%, your loan payments will increase by 17%, assuming a 10-year repayment term.
How student loan interest affects your payments
As with most loans, your monthly mortgage payment is applied first to interest and last to principal. During the first few years of repayment, interest will make up a larger portion of your monthly loan payment. However, as you pay off your debt, interest will become a smaller percentage of your monthly loan payment.
For example, a $10,000 loan with a 5% interest rate and a 10-year repayment term would result in monthly payments of $106.07. $41.67, or approximately 39%, of your first month’s payment will be applied to new interest accrued. By the end of the fifth year, the interest portion of your monthly loan payment was down to $23.76, or about 22%. By the final year of the loan, the interest rate had dropped to less than 5% of the monthly loan payment and less than 0.5% of the final payment.
However, on average over the entire repayment period, interest is only 21% of your monthly loan payment.
Source: College Investor
In the typical interest rate range for federal student loans, interest only amounts to about 10% to 20% of your monthly loan payment over a 10-year term.
Over a 25-year term, interest equals approximately 25% to 40% of your monthly student loan payment.
Student loan payments are applied first to the interest that has accrued since the last payment, and then to the principal balance of the loan. Therefore, a longer repayment period and lower monthly student loan payments means that your loan balance will pay down your loan balance more slowly because less money will be applied to your principal balance. The interest portion of the loan payment remains the same, so more of each payment goes toward interest. The total amount of interest paid over the life of the loan will also be higher.
Related: How much money does the government make from student loans?
Impact of student loan interest deduction
Student loan interest costs are offset somewhat by student loan interest deductions. Interest paid on federal student loans and most private student loans can be deducted up to $2,500 from a borrower or cosigner’s federal income tax return. This is considered an above-the-line deduction from income, so taxpayers can claim the student loan interest deduction without having to itemize.
The deduction is phased out for single and joint filers at incomes of $70,000 and $145,000 and completely eliminated at $85,000 and $175,000. Not available to married borrowers who file separate tax returns.
According to IRS income statistics data, 12.7 million taxpayers claimed student loan interest deductions in 2019, totaling $14.1 billion. This works out to an average of $1,112 per taxpayer. The 22% tax bracket is the largest tax bracket eligible for the full student loan interest deduction, meaning the average taxpayer could save up to $245 on their federal income tax return. If the borrower paid $2,500 in interest and taxes were in the 22% range, the maximum potential savings was $550.
Borrowers who were eligible for payment suspensions and interest forgiveness during the pandemic may have earned little or no interest from 2020 to 2023 that is eligible for the student loan interest deduction. Therefore, although IRS income statistics reports for these years are not yet available, they are likely to be significantly lower than in 2019.
Impact of income-based repayment plans
With an income-driven repayment plan, your monthly loan payments are set as a percentage of your discretionary income, so interest doesn’t affect how you repay your student loans under this plan.
Especially considering that at the end of the repayment period, the remaining balance will be forgiven. Newer plans like SAVE also waive interest accrued beyond your monthly payments.
Considering that over 50% of student loan borrowers are on income-driven repayment plans, the interest rates on these student loans are not up for debate.
Effect of interest on student loan repayment amount
The most significant issue regarding student loan affordability is the amount of debt, not the interest rate.
Of course, making your repayment period as long as possible will increase the total interest you pay over the life of your loan. Doubling the repayment period also more than doubles the total interest paid over the life of the loan. A longer repayment term reduces the portion of each payment that is applied toward the principal balance of the loan, maintaining the loan balance at a higher level. It also charges interest over a long period of time.
However, regardless of the interest rate or repayment period, the amount borrowed must be repaid.
Even if the interest rate is permanently set to zero, the principal of the loan must be repaid.
Government subsidies have not kept pace with increases in college costs. This would shift the burden of paying for college away from the federal and state governments and onto families. With household incomes flat for decades, families don’t have more money to pay for college. They are forced to choose between sending their children to less expensive colleges, such as private to public universities, four-year to two-year colleges, or taking on more debt to pay for higher college costs. Masu.
As the average amount of debt at graduation increases, more students graduate each year with more student loans than they can afford.
If the total student loan debt at the time of graduation exceeds the borrower’s annual income, it will be difficult to make monthly loan payments over the 10-year repayment period. You should choose a longer repayment period, such as extended repayments or income-based repayments.
