interest profits and principal balance

The Game Lenders Play and Some Numbers You Should Know

Michael Lux Blog, Student Loans 0 Comments

There are many numbers that are important to individual borrowers when it comes to their student debt.  Most people have a pretty good idea of their monthly payments, interest rates, and loan balances.  While these numbers are undoubtedly important, one figure that is often overlooked is the amount paid to principal vs. the amount paid to interest.  A close look at these numbers reveals a game being played by many lenders.

We recently heard from a borrower who had paid back over $11,000 towards one of her student loans.  She was shocked to learn that only about $1,000 of that went towards the principal balance debt.  The other 10k paid back interest.

This problem is all too common.  Most people realize that low interest rates are good, but if your monthly payments are only slightly more than the monthly interest, you will spend a ton of money on your loan.

One way to look at things

Instead of calling the terms principal balance and interest repaid, let’s call these terms what they really are.  While interest is certainly an accurate term for accounting purposes, borrowers should call it “lender profits”.  Similarly, principal balance could more accurately be described as “amount owed”.

Now look at your most recent statement from your lender.  How much went to “lender profits”?  How much went towards “amount owed”?  Going back to our example from the beginning, almost all of that borrowers payments went towards lender profits with only a small percent being applied to what she already owes.

The Game Being Played

Lenders don’t care how much they make from you this month.  They are in it for the long haul.  In an ideal world for them, you would make interest only payments forever.  No principal balance gets repaid, just constant profits for your entire life.

For too many borrowers, the minimum payment on all of their student loans is the amount they pay.  It is the number on the bill, so it is the exact number they write the check for.  The problem is that this number may be unnecessarily low for many borrowers.  If you are easily making your student loan payments each month, this is especially true.  Paying more towards student loans could reduce the repayment length by years.

Conversely, if you are barely able to make payments at the minimum, only to have it all go towards lender profits, maybe it is time to explore other options that work better long-term.

A Lesson From Credit Cards

Take a look at your most recent billing statement from your credit card company.  On the bill you will see information about how much it would cost you to only make minimum payments.  Next to that number, you will see how much you could save by paying a little extra each month.  The message is clear to consumers, pay the minimum and spend a lot in the long run.  Pay a little extra now, and save a ton in the future.

Unfortunately, student loans don’t have the same billing requirements as credit cards, so this information is not required to be shown on statements.  Even though it isn’t there, the concept remains the same.

If your payments barely put a dent in what you owe…

The most effective route is to take your business to a new lender where you can get a lower interest rate.  If you move your debt over to a company like SoFi, you could get interest rates as low as 2% (though this is for a variable rate, short-term loan… so it will be higher for most borrowers).  The strategy here is the pick the shortest repayment length that you can comfortably afford.  The shorter the repayment length, the better rate you will get.  Also, picking a shorter repayment length means a higher percentage of your payments will pay down your debt.

Even if you don’t have the income or credit score to work with a consolidation company, there are still options.  For example, if you are barely able to afford your private loan payments with Navient, you might look into the rate reduction program.  Under this program, borrowers are able to temporarily get a lower interest rate so that they can keep up on their loans.  This program allows borrowers to pay less each month, but have more of it count towards the principal balance.

If you can’t improve the terms of your current loan, then it comes down to the math.  How much extra can you afford to pay towards your student loans each month?  Paying more now means less lender profits and sooner freedom from debt.  Here are some suggestions for picking your plan.

Bottom Line

Principal vs. Interest… Knowing where your payment is going and learning how to make the most of it is critical.  The more of your payment that goes towards principal, the better you are doing.