Taking out a loan is often necessary to cover large expenses like buying a house, paying for college, or purchasing a car. But loans come at a cost – you’ll end up owing more than you originally borrowed due to interest and fees charged by the lender.
While you may expect your loan balance to steadily decrease as you make payments, you may be surprised to see it actually increase over time. This can happen for several reasons.
In this comprehensive guide, we’ll explain the key factors that cause your total loan balance to rise and provide tips on how to minimize the costs. Read on to gain a full understanding of what goes into your loan balance so you can manage your debt effectively.
How Interest Can Increase Your Loan Balance
The interest rate on your loan is one of the main drivers behind an increasing loan balance. Interest causes your balance to grow in two key ways:
Interest Accrual
Interest accrues (accumulates) daily based on your principal balance. The amount of interest that accrues each day is determined by your interest rate.
For example:
- You take out a $10,000 loan with a 10% annual interest rate
- Your daily interest rate would be 10%/365 days = 0.0274%
- On day 1, your interest accrual would be $10,000 x 0.0274% = $2.74
- On day 2, your interest accrual would be $10,002.74 x 0.0274% = $2.74
- And so on…
As you can see, interest accrues every day and keeps adding to your balance. This process continues until the loan is fully paid off.
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Capitalization of Interest
Accrued interest can be “capitalized”, meaning it gets added to the principal balance of your loan. This most commonly happens when you enter repayment after a grace period, deferment, or forbearance period.
For example:
- You have $10,000 in student loans at a 10% interest rate
- You don’t make payments during a 6-month grace period after graduation
- At the end of the grace period, you’ve accrued $500 in interest
- The lender capitalizes the $500 interest, raising your new principal balance to $10,500
- Interest now accrues on the new higher balance of $10,500
As you can see, capitalization significantly increases the total amount you end up paying over the life of the loan.
The impact is even more pronounced with higher interest rates or longer periods when payments are postponed. Avoiding capitalization is key to controlling your loan balance.
The Effect of Fees on Your Loan Balance
Beyond interest, the fees charged on your loan can also increase your overall balance. Here are some common fees to watch out for:
Origination Fees
Origination fees are charged upfront when you take out the loan. The fee is usually a percentage of the total loan amount. For federal student loans, this is around 1-2%.[1]
Origination fees get deducted from the disbursed loan amount. For example, if you are approved for a $10,000 loan with a 2% origination fee, you would receive $9,800 ($10,000 – 2% fee) but still owe payments on the full $10,000.
While origination fees don’t directly increase your loan balance, they effectively increase the total amount you end up repaying.
Late Fees
If you miss a loan payment, you will likely get hit with a late fee. This fee gets tacked on to your account balance.
For federal student loans, the late fee is up to 6% of the missed payment amount.[2] On a $300 monthly payment, that comes out to an extra $18 added to your balance.
Late fees can quickly snowball if you continue to miss payments. Even a single missed payment can add hundreds of dollars in extra interest costs over the life of your loan if the late fee capitalizes.
Returned Payment Fees
If you make a payment but your bank account has insufficient funds, the lender will typically charge a returned payment fee.
For federal student loans, this fee is $38 as of 2022.[2] The fee gets added to your loan balance if it goes unpaid.
Collection Fees
If you default on your loan payments, your account will get sent to collections. The collections agencies then charge their own fees for their efforts to recover your debt.
Collection fees depend on the agency but often are around 20-30% of the outstanding loan balance.[3] This gets tackled on to the total balance you owe.
Avoid missed and late payments to steer clear of returned payment and collection fees that inflate your loan balance. Get in touch with your lender immediately if you ever expect to miss a payment due date.
READ ALSO: Biden Student Loan Forgiveness Plan: Eligibility, Impact, and Complexities
Loan Term and Repayment Plan Effects
The loan term and repayment structure impact your total costs. Let’s look at how:
Loan Term
The loan term is the length of time you have to repay the loan, such as 5 years, 15 years, or 30 years.
Longer loan terms usually come with lower monthly payments but higher total interest costs over the life of the loan. Shorter terms have higher monthly payments, but you’ll pay less interest in the end.
For example, if you borrowed $100,000 at 6% interest:
- On a 5-year term, your monthly payment would be $1,954 and you’d pay $18,709 in total interest
- On a 15-year term, your monthly payment would be $849 and you’d pay $58,224 in interest
- On a 30-year term, your monthly payment would be $599 and you’d pay $154,080 in interest
As you can see, the 30-year term cuts your monthly payment almost in thirds compared to the 5-year term. But that convenience comes at the cost of over $135,000 extra in interest paid!
Carefully consider whether lower payments now are worth paying significantly higher costs over the long run. Opting for the shortest term you can afford will minimize your total interest expenses.
Income-Driven Repayment Plans
Federal student loans offer income-driven repayment plans that base your monthly payments on your discretionary income and family size.
The benefit is you get a more affordable payment. The tradeoff is you may ultimately pay more interest over the loan term.
That’s because on income-driven plans, your required payment may not even cover all the interest accruing each month. This causes “negative amortization”, where your balance grows despite making payments.
For instance:
- You owe $30,000 at 6% interest
- On the standard plan, your payment would be $333/month
- On an income-driven plan, your payment is reduced to $200/month
- But $30,000 at 6% interest accrues $150 in interest each month
- Since your $200 payment doesn’t cover the $150 interest, your balance increases
In this example, you’d be better off finding a way to pay the $333 standard payment, rather than go on an income-driven plan and increase your total costs.
Run the numbers for your own situation before pursuing an income-driven repayment plan. It can end up costing you tens of thousands more in the long run.
Strategies to Reduce Your Loan Balance
While the above factors can all increase your total loan balance, you’re not entirely at their mercy. Here are proactive steps you can take to keep your loan costs as low as possible:
Make Payments During Grace Periods
Student loans generally have 6-month grace periods after graduation before payments are due. But interest continues accruing.
Making interest-only payments during the grace period prevents accrued interest from capitalizing. This keeps your principal balance and future interest costs lower.
For example:
- You have $30,000 in student loans at 5% interest
- Monthly interest is $125 ($30,000 * 0.05/12)
- You make $125 monthly payments during the 6-month grace period
- Total interest accrued is $750, but your principal stays at $30,000
Compare this to if you hadn’t made payments:
- $30,000 principal at 5% interest accrues $1,500 over 6 months
- The $1,500 interest capitalizes, raising your principal to $31,500
- Now your monthly interest costs are higher at $131.25 ($31,500 * 0.05/12)
Making payments during the grace period saved $6+ in monthly interest and prevented your balance from inflating by $1,500!
Pay More Than the Minimum
Paying extra on your principal balance helps reduce the total interest you pay over time. This saves you money and lets you pay off the loan faster.
Most lenders apply your monthly payments to any outstanding fees and interest first before the remaining amount goes to the principal.[4] By paying extra, more money goes directly to reducing your principal balance each month.
For instance:
- You have $20,000 left on a loan at 6% interest
- Your monthly payment is $377
- You start paying an extra $100 each month, so $477 total
- After one month:
- $377 goes to interest and fees
- The extra $100 takes your remaining principal down to $19,900
- Since interest accrues on a lower principal, your savings start compounding
Check if your lender allows you to direct additional payments specifically to the principal balance. This guarantees the extra money doesn’t just cover next month’s interest.
Refinance at a Lower Interest Rate
Refinancing replaces your existing loan with a new one that hopefully has better terms, like a lower interest rate. This reduces the total interest you pay over time.
For instance, by refinancing a $200,000 mortgage from 4.5% down to 3.5%, you would save over $30,000 in interest and pay off your loan 3 years faster![5]
That said, refinancing federal student loans into a private loan would cause you to lose access to helpful federal programs like income-driven repayment and forgiveness options. Weigh such pros and cons carefully if considering refinancing federal loans.
Pay Off Loans With High Balances or Interest Rates First
If you have multiple loans, consider strategies like the debt avalanche or snowball method to save on interest costs:
- Debt avalanche: Focus on paying off loans with the highest interest rates first, regardless of balance. This minimizes expensive interest expenses.
- Debt snowball: Pay off loans with the smallest balances first, regardless of rates. Knocking out entire loans quickly gives psychological motivation to keep attacking your debt.
The debt avalanche method technically saves you the most on interest, mathematically. But the debt snowball approach also has merit by giving you early “wins” to encourage further repayment.
Evaluate your own financial situation and preferences to decide which strategy may work best for you. The key point is to target high-interest and high-balance debts first.
Key Takeaways
- Interest causes your loan balance to grow through daily accrual and capitalization of unpaid interest. Make payments during grace periods and other deferment periods to avoid capitalization.
- Fees like origination, late payment, and collection fees all get tacked on to increase your total loan balance. Stay on top of required payments to avoid fees.
- Loan terms and repayment structures impact your total costs. Opt for shorter terms and make payments that exceed monthly interest to minimize costs.
- Employ strategies like making extra principal payments, refinancing at lower rates, and targeting high-balance debts first. This maximizes savings on interest expenses over the loan’s life.
- Check with your lender about directing additional payments specifically to the principal balance. This guarantees the extra amount goes straight to reducing your outstanding balance.
By understanding what increases your balance and proactively managing interest and fees, you can pay off your loans faster and reduce the total amount you repay over time.
To Recap
Managing loan balances and minimizing interest expenses takes diligence, but doing so can save you thousands of dollars over the lifetime of your loans. The most effective strategies include making payments during deferment periods, paying extra principal, refinancing at lower rates when possible, and directing any windfalls like tax refunds toward tackling high-balance debts first.
Automating payments helps avoid late fees that tack on even more costs. If you have multiple loans, target the ones with the highest interest rates or smallest balances first. Tailor the debt avalanche and snowball methods to your own debts.
While some increase in an original loan balance may be inevitable due to accrued interest and fees, you are not at the full mercy of your lender. By taking a proactive approach, you can reduce the total interest paid and pay off your loans faster, even if the balance creeps up initially. Keeping a close eye on your account activity and understanding the terms will help you prioritize paying down principal and make smart repayment decisions.
Frequently Asked Questions
Why does my student loan balance increase when I’m in school?
Interest keeps accruing on student loans even while you’re still in school. Typically, this interest gets capitalized and added to your principal balance when you graduate.
Making interest-only payments while in school prevents capitalization and balance inflation. Alternatively, see if you qualify for subsidized federal loans where the government pays the interest during school.
Why does my mortgage balance go up when I make payments?
For adjustable-rate mortgages, your monthly payment may stay constant while your loan’s interest rate fluctuates. If rates increase, your fixed payment won’t cover all the interest. The unpaid interest gets added to your balance, causing an increase.
Paying extra principal helps counter this. Refinancing into a fixed-rate loan can also lock in a stable payment and prevent balance jumps from rate hikes.
Why did my loan balance go up after refinancing?
Closing costs from the refinancing process may get rolled into your new loan balance. For instance, appraisal fees, origination charges, and points can total thousands in upfront costs.
Ask the lender if they offer options to cover closing costs out of pocket instead of financing them. This prevents the refinanced loan amount from being higher than your prior balance.
Why did my student loan balance increase after consolidating?
Federal student loan consolidation lets you combine multiple federal loans into one new loan. Unpaid accrued interest from your prior loans can get added to the consolidated balance.
Consolidating also restarts the clock on certain benefits like interest subsidies and deferment. Be strategic in timing your consolidation to maximize these benefits across both loans.
Can I reduce my loan balance by paying weekly instead of monthly?
Making weekly (or biweekly) half-payments does allow you to make the equivalent of an extra monthly payment each year. This extra principal payment helps pay down your balance faster and reduces total interest costs.
Just beware of the lender assessing extra servicing fees for handling more frequent payments. Also, automate the weekly payments so you don’t forget and incur late fees.
In another related article, How to Use an Online Loan Calculator to Find Your Monthly Payment
