How can people make payments for 20 years on school loans and barely make a dent in the principal? How are those loans different than a mortgage?

Question

How can people make payments for 20 years on school loans and barely make a dent in the principal? How are those loans different than a mortgage?

In: Economics

Answer 1

APR. Annual interest per year. APR is always based on the *current* amount of your loan and it is calculated every month. Your monthly payment always goes to cover interest before any goes to the loan itself. It works like this:

$ Interest = Principle * (APR / 12)

$ Interest is the dollar amount of your interest each month.
Principle is your total loan amount.
APR is that % number that comes with every loan.
12 is the months in a year.

Say you owe $120,000 in private school loans and those loans have 10% APR. Let’s do the math to figure out how much interest you have to pay this month:

$ Interest = 120000 * ( 0.10 / 12 )
$ Interest = $1000

Here’s where the bank gets you. Your required monthly payment is only $1100 dollars! You make your minimum payment of $1100 on your loan. But wait, you owe $1000 of interest now, so that gets paid first. Of your $1100, only $100 went to your actual loan this month.

Now it’s next month and you still owe $119900 on your principle. If you do the same math as before, you only owe $999 of interest this month! Instead of $100 going to your loan, $101 go to the loan.

The loan barely decreases, the bank rakes in money, and the payments are so massive that no realistic amount of savings can be gathered, keeping you in a perpetual cycle of taking microscopic chips out of the loan.

Due to how interest is calculated, a few weird things happen. You m reduce the principle by negligible amounts, which slowly reduces the amount of interest, which means more and more of your payment goes to the principle as time goes on. The bank makes most of its profit up front and has safety mechanisms if you default. Over the course of the loan I listed, you would pay about $200000 in interest. You would pay around 3/4 of that before your loan was even halfway paid off.

Every percent increase in APR increases your total interest paid by *massive* amounts