The content below is from CommonBond.co, explaining all the need-to-know information for us students taking out loans! We will post each day of the 10 days of Student Loan Boot Camp once a week.
Welcome back to Day 2 of CommonBond's Student Loan Boot Camp. [Last time] you learned about average student loan debt in the U.S. and about how student loan refinancing can help you save thousands on your student loans.
Today we're going to discuss the main components of your student loan payments: principal and interest.
Day 2: Principal Versus Interest
Let's define both terms so you can understand how they affect your student loan payments:
Principal refers to the amount you borrow and the amount remaining on your loan, separate from the interest you pay.
Interest is the charge you pay for borrowing money. Interest is usually expressed as annual percentage rate or APR. An APR represents the actual yearly cost of interest over the term of a loan, and includes any fees or additional costs associated with the transaction.
So if you have a $30,000 student loan at a 3.19% fixed rate for 10 years, your principal would be $30,000 and your interest would be 3.19%.
Student lenders offer two types of interest rates:
Fixed rate: A fixed-rate loan is a loan where the interest rate doesn't fluctuate during the period of the loan.
Variable rate: A variable-rate loan is a loan where the interest rate is based on a market benchmark. Most student loan lenders use the London Interbank Offered Rate, or LIBOR, for their variable-rate loans. CommonBond ties the rates of its variable student loans to 1-month LIBOR, which is the estimated rate at which international banks lend to each other in a given month. So if 1-month LIBOR rises, so does the rate on the variable rate student loan. The rates on variable-rate loans tend to be lower than fixed-rate loans with similar terms because you are taking on the risk that interest rates may rise.
Interest accrues on the outstanding balance, or principal, of your loan every day.
To understand the amount of principal and interest you'll pay each month, you can use what's called an "amortization schedule." You can download a spreadsheet to calculate the amortization schedule for a fixed-rate student loan. When you make a payment with most lenders, they will typically apply your payment to the interest that has accrued to date, and then toward the principal of the loan.
Using the spreadsheet, let's walk through an example to see how principal and interest work with a $30,000, 10-year student loan with a 3.19% fixed rate.
With the amortization schedule spreadsheet, you'll see the monthly payment for this example student loan would be $292.32. For the first month of the $30,000 loan when interest begins to accrue, a customer would pay $292.32, with $79.75 of that payment going to interest accrued in that month and the remaining $212.57 going toward principal. After the payment, the customer would have a loan with a principal of $29,787.43 ($30,000 — $212.57).
Next month, the customer would again pay $292.32. But only $79.18 in interest accrued this month because the principal was lowered from $30,000 to $29,787.43. The customer's monthly payment would again first go to pay that interest of $79.18 and then the remaining $213.14 would go toward principal. Now the principal is $29,574.29 ($29,787.43 —$213.14).
This process would continue for 118 months until the last payment when nearly all of the $293.32 goes toward principal and the loan balance is zero.