Upon graduation, student loan borrowers have a 6 month grace period during which time no loan payments are required to be made. Sounds great, right? For many borrowers with “getting started” expenses like security deposits and moving expenses, the grace period can be a real lifeline. However, any payment you can make during the grace period is highly beneficial because unlike a traditional loan payment that is part principal and part interest, a payment during the grace period results in a dollar-for-dollar reduction in the loan balance. Huh?
The reason for that is, interest accrues on the non-subsidized portion of the loan starting the day the loan is disbursed. While the student is in school and during the grace period, the interest only accrues on the original loan balance. However, once the loan goes into repayment at the end of the grace period, the accrued interest is capitalized, or added to the outstanding principal balance.
Let’s say (for the sake of simple math) that a student has $10,000 in student loans at 5% interest that were borrowed two years ago. Every year the loans accrue $500 in interest– $41.67 per month– so after two years there is $1,000 in interest in addition to the $10,000 in loans.
Keeping it easy, let’s say it’s November and the grace period ends in December and the graduate has $700 available that could be used to pay down the loan. By making the payment during the grace period, she pays down $700 of accrued interest and only $300 will capitalize. That means she’ll enter repayment with a loan balance of $10,300 and monthly payments of $109.25 (on a 10-year schedule). She’ll pay a total of $13,109.70 in principal and interest over the life of the loan, including the $700 paid during the grace period.
If she waits until the loan goes into repayment, her monthly payment will be $116.67 and she’ll pay $14,000.65 over the course of the loan. And that $700 that went to principal if paid in November would be reduced by the interest payment of about $45 if paid after repayment begins. The extra $7 monthly might not seem like such a big difference, but over the course of the loan she’ll pay almost $1,000 more.