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
Generally speaking, a mortgage isn’t given to a 17-18 year old with no real job prospects or established career or credit.
I don’t know why nobody has said this yet, but student loans tend to have much higher interest rates than most homes. Many people with homes took advantage of 2-3% mortgages. Many student loans are 6-8%. You also can’t refinance a student loan to get a lower interest rate. Or get a renter or roommate to help you pay.
You also need to pay a student loan WHILE paying for your mortgage / rent, too. Whereas many people paying mortgages may be paying it as a main payment and not have other debts.
I made a student loan payment a few weeks ago for $150 and it said $3 went to principal. 😥
Because they’re knowledge in personal finance is lacking and they only pay off the interest? If you can, pay off any high interest loan as fast as you can (minimum payments ain’t gonna cut it).
The other thing that happens and that people don’t seem to grasp is something called “negative amortization”. If your minimum payment isn’t enough to pay the outstanding interest that month then the unpaid interest is *added* to the loan principal… and *that* starts accruing interest as well! It’s like compound interest in reverse. Many people on income-based payment plans or deferral programs don’t seem to grasp this. That’s how we get crazy-ass stories of people paying on their loans for 20 years and still owing much more than the original balance.
Most every other loan product that consumers deal with either are completely amortizing (e.g. a mortgage that calculates the payments so you’re completely paid off over 15/30 years) or in the case of revolving lines of credit the minimum payment is calculated to at *least* cover all of the outstanding interest. They don’t even know that negative amortization is a thing until it bites them in the ass like this…
Student loans have a lot of ways to temporarily reduce your monthly payments. But doing that means that you pay it down slower and, sometimes, don’t even pay off the interest that accrues.
Plus, with any long term loans, the first years almost all go to interest. But, as you pay down the principal, more and more of each payment goes to principal.
I don’t think it was mentioned here, but in student loans there are certain events that can trigger capitalization of interest. This means that accrued interest is added to the principle of the loan and now accrues interest. Then you wind up paying interest on your interest. Awesome, right?
The first big issue is people can take out massive loans for fields that stand no chance of ever paying then off. Low paying careers like art or hospitality can take out the same loans as engineers. But then they graduate making half The salary.
The second big issue is student loans start accruing interest IMMEDIATELY. This means while you’re in school learning, the loans are already growing. You don’t have to make payments since you’re in school, but that doesn’t stop the interest from making them grow. So when you graduate you’re already behind. Fun.
Luckily there are some ~~shitty~~ tools we can use to make things ~~worse~~ easier.
The first is deferment. You can pause payments after graduating when you get your first job being underpaid as a college graduate. But just like in school, just because you’re not paying on the loan doesn’t mean the loan isn’t accruing interest. So they get even bigger. Deferment can last for a couple of years.
Then there’s income based repayment. If you’re income is under a certain level they will reduce how much you need to pay on the loans so you don’t default. That’s great, but again, the loans still accumulate interest, except now you’re paying less on them. So they grow more than your payment shrinks them, so they get bigger.
There’s also a regular recent graduate payment reduction program for people that make too much to qualify for income based, but can’t afford the loans for other reason. The payment reduction isn’t as much as the income based option, but still enough that the interest grows more than the payment.
If you didn’t notice there’s a pattern. The interest never stops making the loans grow, no matter how far behind you get or how low your income is.
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
Not sure why nobody has answered this question yet, everyone just trying to explain interest. The ELI5 answer is mortgages are set for a period (15 years, 30 years, etc) where you make the same payment every month to pay it off in that period. Your minimum amount is literally what payment is needed to hit that period payoff. Student loans aren’t structured like this, you can pay a minimum amount that is very low (think $50 a month) that will never get you there in a reasonable time period.
And before anyone says it, yes I know this is a gross simplification and you could pay over on your mortgage amount if you’d like
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