How much does student loan interest really matter when it comes to paying back a student loan? What is the impact of interest on loan repayments?
One of the most popular “alternatives” to avoid student loan forgiveness is the argument that the federal interest rate on student loans should be set at 0%. But given the wide range of student loan forgiveness and other assistance programs — does your student loan interest rate really matter?
Let’s take a look at how interest rates affect your student loans.
Don’t double my rate
In 2006, Democrats included a pledge to halve student loan interest as part of their pledges for the “Six for ’06” midterm election campaign. When it came time to fulfill this promise, they limited it to subsidized Federal Stafford loans only for undergraduate students and gradually introduced the rate cut. They cut interest rates from 6.8% over four years, to 6.0%, then 5.6%, then 4.5% and finally to 3.4%.
The legislation was due to expire in 2012, bringing the interest back to 6.8%. This led to the ‘Don’t Double My Rate’ campaign. After all, if student loan interest was a winning issue for one election, why not use the issue for another?
Some borrowers reacted to the prospect of interest rates doubling on new student loans by saying they couldn’t afford to double their student loans.
But doubling the interest on a student loan does not double the monthly student loan payments.
Doubling the interest on a federal student loan increases the monthly loan payment by only about 10% to 25% over a 10-year term. For this particular situation, an increase in the interest rate from 3.4% to 6.8%, loan payments would have increased by 17%, assuming a 10-year repayment term.
Impact of Interest on Student Loan Payments
As with most loans, the monthly loan payment is applied first to the interest and last to the principal. The interest starts as a large part of the monthly loan payment in the first few years of repayment. But as you progress toward paying off the debt, the interest represents a smaller portion of the monthly loan payment.
For example, a $10,000 loan at 5% interest with a 10-year repayment term has a monthly payment of $106.07. Of the first month’s payment, $41.67, or about 39%, is applied to the new interest that has accrued. By the end of the fifth year, the interest portion of the monthly loan payment has fallen to $23.76, or about 22%. In the last year of the loan, the interest has fallen to less than 5% of the monthly loan payment, to less than 0.5% of the final payment. However, on average over the entire repayment term, the interest is only 21% of the monthly installments.
Percentage of payment of principal and interest over 10 years
For the typical interest range on federal student loans, the interest represents only about 10% to 20% of the monthly loan payment over a 10-year term.
Over a 25-year term, the interest represents approximately 25% to 40% of the monthly student loan payment.
Student loan payments are applied first to the interest accrued since the last payment, and then to the loan principal balance. Thus, the lower monthly student loan payment due to a longer repayment term means that the progress in paying off the loan balance is slowed down as less is applied to the principal balance. More of each payment is applied to interest as the interest portion of the loan payment does not change. The total interest paid over the life of the loan is also higher.
Related: How Much Money Does the Government Benefit From Student Loans?
Impact of the interest deduction for student loans
The cost of student loans is somewhat offset by the student loan deduction. Up to $2,500 in interest paid on federal student loans and most private student loans can be deducted from the borrower’s or cosigner’s federal income tax returns. It is considered an excessive income exclusion so that the student loan deduction can be claimed even if the taxpayer does not specify it.
In 2021, the deduction will begin to phase out at $70,000 and $145,000 in income for single and joint filers, and will be phased out completely at $85,000 and $175,000. It is not available to married borrowers who file tax returns separately as a married return.
Based on IRS Statistics of Income data, 12.7 million taxpayers claimed student loan deductions in 2019, a total of $14.1 billion. That works out to an average of $1,112 per taxpayer. Since the 22% tax bracket is the maximum tax bracket eligible for the full student loan deduction, that means the average taxpayer has saved up to $245 on their federal income tax return. The maximum potential savings was $550 if the borrower paid $2,500 in interest and was in the 22% tax bracket.
Borrowers who were eligible for the payment break and interest exemption during the pandemic may have had little or no interest in qualifying for the student loan interest deduction in 2020 and 2021. perhaps much lower than in 2019.
Impact of the payment pause and interest exemption
During the pandemic, borrowers with federal student loans held by the U.S. Department of Education were eligible for an automatic payment break and interest exemption. As a result, the repayment obligation was suspended and the interest was temporarily set to zero.
This offered borrowers a significant amount of financial relief, as they didn’t have to pay anything on their eligible federal student loans.
The cost to the federal government was just under $5 billion in interest per month. That’s a total cost of $127 billion over the 26 months from March 2020 through April 2022.
The 41 million borrowers eligible for the payment break and interest exemption save an average of about $119 in interest per month, for a total savings of about $3,100 in interest per borrower during the 26 months of the payment break and interest exemption.
The paused payments incur additional costs for the federal government. The interrupted payments count toward loan forgiveness after 10 years in the Public Service Loan Forgiveness (PSLF) program and after 20 or 25 years in an income-driven amortization plan, as if the payments had been made. This reduces the number of payments required under PSLF by more than a fifth and by as much as 10 percent under an income-driven repayment plan.)
The average federal student loan payment among borrowers who are actively repaying their student loans is $393 per month, according to the Federal Reserve Board’s 2018 Report on the Economic Well-Being of U.S. Households. Thus, the waived interest represents about 30% of the average student loan payment.
So most of the financial benefit of the payment break and interest exemption comes from the payment break, not the interest exemption.
The impact of interest on student loan affordability
The main problem with student loan affordability is the amount of debt, not the interest.
If you extend the repayment term as long as possible, you will of course pay more total interest over the term of the loan. Doubling the repayment term more than doubles the total interest paid over the life of the loan. A longer repayment term keeps the loan balance at a higher level by reducing the portion of each payment that is applied to the principal balance of the loan. It also charges interest for a longer period of time.
But regardless of the interest rate and the repayment term, you still have to repay the borrowed amount.
Even if the interest is permanently at zero, you still have to repay the principal of the loan.
Government grants have not kept pace with the rise in college costs. This shifts the burden of paying for college from the federal and state governments onto the families. Because family incomes have been stable for decades, families no longer have the money to pay for their college expenses. They are forced to choose between sending their children to cheaper colleges, such as moving from private to public colleges and 4-year colleges to 2-year colleges, or borrowing more to pay the higher tuition costs.
As the average debt at graduation has increased, more students graduate each year with a prohibitive amount of student loans.
If the total student debt at graduation exceeds the borrower’s annual income, they will struggle to pay the monthly loan payments with a 10-year repayment term. They will have to choose a longer repayment term, such as extended repayment or means-tested repayment.
This post How Much Does Your Student Loan Interest Rate Matter?
was original published at “https://thecollegeinvestor.com/39690/does-your-student-loan-interest-rate-matter/”