Why does most of my payment go towards interest instead of principal?

Michael Lux Blog, Student Loans 0 Comments

The only thing worse than parting with huge amounts of money to pay student loans is realizing that the big check you just wrote will barely touch your balance.  How is it that lender’s are able to apply most, or even all of your payment, towards interest instead of lowering the principal balance?  Today we will look at how payments are usually applied and why things are done the way they are.  Finally, we will go over a couple options that can be used to make sure more of your payment goes towards the principal balance.

How come so much of the payment is interest?

Interest on student loans can be killer.  Unlike credit cards, where consumer protection laws limit how much of a minimum payment can go towards interest, student loan borrowers do not get any protection.

The profits for the lenders are based upon the interest they are able to collect over the life of the loan.  The more interest you pay, the more income they generate.  As a result, they will set up payment plans and minimum payments so that most of your payment is being applied to interest.  It is much more profitable for a lender to loan someone $10,000 and have them pay it back over 30 years than to have someone pay it off in ten.  The longer you have to pay off your student loans, the higher the percentage that will be applied to interest.  This is especially true for loans that have recently entered into repayment.

The thing to remember with the interest is that your loan is generating it every single day.  The reality is that your balance is going up each day.  If your monthly payment barely covers the growth due to interest, there will be almost nothing left for the principal balance.

The way payments are handled…

When you pay your lender each month, they have a planned process for determining where the money goes.  The first thing they will look at is whether or not you have any fees or penalties.  Before your payment goes anywhere, it is first put in the direction of fees and penalties.  Once the fees have been paid off, the next step is paying off the interest that accumulated in the past month.  If you have a high balance or a high interest rate, or both, your loans could be creating large sums of interest.  It is only when this monthly interest growth is paid off that the remainder of the payment can be used to lower the principal balance.

If you are wondering why lenders handle payments in this manner, the answer is all about profit.  The longer you have a loan, the more interest they can collect.

How can I get more of my payment to go towards the principal balance?

Unfortunately, you cannot just tell your lender to put the payment towards the principal balance instead of the interest owed.  This situation leaves the average borrower with two options, pay more each month or lower the interest rate.

Most borrowers are amazed to see at how much paying just a little extra makes a difference.  If you are not happy with the tiny dents you are putting into your student debt, paying extra each month can make it disappear much more quickly.

An even better option to making your payments more productive is to get a lower interest rate.  By doing so, the same monthly payment will do much more damage to your principal balance.  Unfortunately, lenders very rarely will just lower the interest rate at a borrower’s request.  Normally the way to get interest rates lowered is to take your business elsewhere.  There are a large number of student loan consolidation companies that will pay off your old high interest student loans and then allow you to pay off a new loan to the new lender at a hopefully much lower interest rate.  This is also commonly called refinancing the loan.  Many borrowers are able to get lower interest rates because their credit score and income has improved since the time they were a college student.  The less risky a loan is, the lower interest rate the borrower can get.  Competition among the refinancing companies has gotten so competitive that lenders like SoFi and CommonBond will even pay new borrowers $150 just for signing up.

The Bottom Line

Lenders are in the student loan business to make money.  Every day that you have a student loan balance, that balance is generating profits for the lender in the form of interest.  Unless you pay more each month or find a way to lower your interest rate, chipping away at your loan debt will take a great deal of time.