Why You Should Start Paying Interest on Student Loans Immediately

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Whether you’re just starting college or are entering your senior year, chances are you’ve taken out student loans somewhere along the way. With many student loans, you aren’t required to make payments at all until about six months after you’re no longer enrolled in school full-time.

That’s a good thing, right? Well, maybe not.

In fact, making absolutely no payments on your student loans while you’re in school can mean that you graduate with a lot more debt than you expected. That’s because interest accrues on some of these loans while you’re still a student.

Did I lose you? Don’t worry. Here’s a quick primer on what all that means for you.

Understanding How Interest Works on Federal Student Loans

First, know that we’re mainly talking about federal student loans here. If you have private loans, they may work differently. Check your loan paperwork to find out.

When it comes to federal student loans, though, they fall into two main categories: subsidized and unsubsidized.

You have to meet certain income qualifications to get subsidized student loans. If you qualify, the government will pay the interest on these loans while you’re still enrolled in school. We’ll see in a moment why that’s advantageous.

On the flip side, the government does not pay interest on unsubsidized student loans while you’re in school, but you’re still not required to make payments.

On unsubsidized loans, interest is charged from the day the loan is issued. You can figure out this date from your loan paperwork. So if you have a loan with a 5% interest rate, that annual interest is charged starting on the issue date.

Most loan interest is compounded daily, meaning that the total interest rate is divided by the number of days in the year. Each day, the lender charges that amount of interest on the loan’s outstanding balance.

So if you don’t make any loan or interest payments while you’re in the grace period, your interest continues to accrue. The longer you go without making payments, the more interest will accumulate.

This, in and of itself, isn’t the end of the world. You can always catch up on interest payments once your grace period is over. However, capitalization can turn accrued interest into a huge problem.

At certain points in the life of your loan—like when your grace period ends or after you exit a period of deferment—any unpaid interest on the loan capitalizes. This means that the unpaid interest is added to the loan’s principal balance. Then your interest is calculated based on that new, higher balance. So not only do you have a higher balance to pay off, but your interest payments are higher each month, too.

Doing the Math

This is all kind of confusing, so let’s look at how the math breaks down.

Let’s say you take out a $10,000 unsubsidized federal student loan at 5% annual interest. You’ll pay 0.013699% interest daily. Doesn’t sound like much, but it comes out to about $1.37 each day. So over the course of a month, you’ll accrue roughly $42 in interest.

Again, that doesn’t sound like a lot of money, so what’s the big deal?

Well, play this out over the course of your college career. You take out this loan as a freshman, and you let interest accrue for your entire school career, including the six-month grace period after you graduate. Let’s say that totals 54 months.

In 54 months, your total interest accrued on the loan is around $2,268. If that interest capitalizes when your grace period ends, your principal balance is now $12,268. That means your daily interest is about $1.68, making your monthly interest about $51.

Again, it doesn’t seem like a huge amount of money. But multiplied by several years’ worth of student loans, it can really add up.

This is just a general example, though. You can use this calculator to determine just how accrued interest could affect your particular student loans.

Making Interest-Only Payments

Even if you can’t make full interest-only payments, paying what you can to reduce your loans’ capitalized interest is a smart idea. To figure out how to do this, just get in touch with your student loan servicer. Usually you can send in your payments online.

Since you’re not technically on the hook for paying off your loans, you don’t have to make payments every month. But if you come into some extra cash or get a paid internship, consider devoting some of your budget to paying off your student loan interest.

Student loans can be overwhelming, but paying off interest as you go is one way to pay less in the long run. If you have more questions on the best way to tackle your loans, check out these additional student loan resources for expert answers and guidance.

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Here’s How Your Student Loans Can Get You a Tax Break

Paying interest is no fun, but if you have student loan debt, you don’t have much choice. Fortunately, the government offers a break. Here's how to get it.

Paying interest is no fun. But if you have student loan debt, you don’t have much choice.

Wouldn’t it be great if the government gave you a break on that student loan interest you pay each year?

Well, here’s some good news: You might be able to deduct a portion of student loan interest from your taxable income — up to $2,500 — thanks to the student loan interest tax deduction. Find out if you qualify for this deduction and learn how to claim it below.

How the Student Loan Interest Tax Deduction Works

The IRS lets you claim the student loan interest tax deduction on Form 1040, Line 33. Because it’s considered an “above the line” deduction (i.e., an adjustment to your income), you don’t have to itemize your taxes in order to claim it.

Keep in mind, this is a deduction and not a credit. That means claiming this deduction will reduce your taxable income by up to $2,500. In terms of real dollars saved, your total tax bill could be reduced by up to $625, depending on your income and how much student loan interest you pay.

Who Qualifies for the Deduction?

There are three qualification criteria you need to meet in order to claim the student loan tax deduction:

  1. Have a Qualified Student Loan: First, you need to have a qualified student loan. The IRS says that the loan must be taken out to pay for qualified education expenses. Not only that, but it can’t be a loan from someone related to you, or provided as part of a qualified employer plan. So, if your grandma offers you a loan for your education, and you pay interest to her on top of making principal payments, you can’t deduct that interest. The same is true if your employer offers student loans as part of a company benefit. Only loans from the federal government or a private lender will qualify.
  2. Be a Qualified Student: Next, the loan must be taken out on behalf of a qualified student in order to deduct the interest. The student can be you, your spouse, or your dependent. So, you can still deduct student loan interest from your income, even if the loan is financing your spouse’s or child’s education and not yours. However, no matter who that student is, they must have been enrolled at least half-time in a program at an eligible educational institution when the loan was taken out. The program should lead to a degree, certificate, or other recognized credential.
  3. Meet Income Requirements: Finally, there is an income requirement. The IRS won’t let you claim the student loan interest deduction if your modified adjusted gross income (MAGI) is at least $160,000 if married filing jointly or $80,000 for other filing statuses.

To see if you qualify and find out how much you might personally save on your taxes, you can use a student loan interest deduction calculator to run the numbers. The IRS also offers a handy tool to determine if you qualify for the deduction. It takes about 10 minutes to complete.

How the Deduction Impacts Your Tax Bill

Realize that a tax deduction reduces your income; it doesn’t mean a dollar-for-dollar reduction in what you pay in taxes (that’s a credit). With a tax deduction, your tax bill is smaller because your taxable income is lower.

In the case of the student loan interest tax deduction, the maximum tax benefit is $625. Your actual tax benefit is determined by your income, filing status, and how much you paid in student loan interest.

Say you file single, your MAGI is $45,000, and you paid $800 in student loan interest. Your income might be reduced by $800, but the actual impact on your taxes is to lower what you pay by $200.

It’s still a reduction in what you owe, and when you combine the student loan interest tax deduction with other deductions and credits, it can make a big difference in your final tax bill (or refund).

How to Claim the Student Loan Interest Tax Deduction

Start by taking a look at how much you paid in interest (not your total student loan payments). That information can be found on Form 1098-E. Each of your student loan servicers should send you a copy. You can find the interest you paid in Box 1.

Add up the amounts from all your forms and enter it on your tax form in the appropriate place. However, you might need to make sure you meet the income requirement.

According to the IRS, your MAGI is basically your adjusted gross income (Line 37 of the Form 1040) after adding back in certain deductions. Some of the deductions you add back in include:

  • Student loan interest
  • One-half of your self-employment tax
  • Tuition and fees deduction
  • IRA contribution deduction
  • Certain investment losses
  • Exclusion for adoption expenses

For example, your adjusted gross income might be $40,000. However, you claimed $3,000 in IRA contributions and $1,000 in student loan interest. Plus, your side gig meant a self-employment tax deduction of $500. That’s $4,500 in deductions. To calculate your MAGI, add that $4,500 back to your adjusted gross income. You end up with a MAGI of $44,500.

As long as your MAGI meets the IRS income requirements, you can still claim the deduction. If all those deductions you’re claiming put your MAGI over the top, you have to erase the deduction from your form.

The student loan interest tax deduction can be a great way to reduce your taxable income and lower your tax bill. It’s best used in conjunction with other tax breaks, so consider consulting a tax professional to find out how to best take advantage of all your options. You can find a quick guide to other common tax deductions and exemptions here.

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Student Loan Interest Rates Set to Drop July 1

There’s very little to celebrate when it comes to taking out student loans, but if you’re borrowing for the coming academic year, you have reason to let out a small cheer: Your loans will be cheaper.

That is, they will be if you’re taking out Federal Direct Loans (the most common kind), because the new interest rate on these loans goes into effect July 1, and it’s the lowest rate these loans have had in years.

When President Barack Obama signed a new student loan bill into law in 2013, an annual reset of federal student loan interest rates began. That law tied interest rates on government education loans to the 10-year Treasury note yield, and every year, the rates are set by the last auction of that note before June 1. For the interest rate that will be in effect from July 1, 2016, to June 30, 2017, that auction happened May 11, when the high yield of the 10-year note was 1.71%.

Add 2.05 percentage points to that yield, and you have the new interest rate of 3.76% for the undergraduate federal student loans (Congress wrote that into the 2013 law to cover the administrative costs of issuing the government-backed loans). Graduate students and parent borrowers will have a 6.31% interest rate.

Last year, interest rates on the same loans were a tad higher: 4.29% for undergraduate borrowers and 6.84% for graduate students and parent borrowers (parent loans are called PLUS loans). In 2013, Congress set a cap on how high these interest rates can get (8.25% on undergraduate Direct loans and 9.5% on graduate and parent PLUS loans), but contrary to many estimates when this process first became law, the interest rates haven’t climbed much closer to those rate caps. While the underlying factors behind these low interest rates may not mean great things for savers and the overall economy, at least student loan borrowers can enjoy relief in this area.

Of course, these low rates only apply to the loans taken out in the next 12 months. Existing borrowers have to deal with the interest rates as they were when they took out their loans, unless they look into refinancing their loans with a private lender. (The Education Department doesn’t offer student loan refinancing, though some borrowers may qualify for a Direct Consolidation Loan. Still, federal student loan consolidation doesn’t lower your interest rate — it averages the rates of all the loans you’re consolidating, which doesn’t translate into interest savings.)

The interest rate is only one part of what determines a borrower’s student loan payment, and if you’re struggling to afford yours, there may be some things you can do to ease the burden. Federal student loan borrowers may qualify for income-based repayment plans, student loan forgiveness or other repayment options that can bring short-term relief from high debt.

However you go about it, paying your student loans is incredibly important, because they generally cannot be discharged in bankruptcy, and, like any debt, student loans influence your credit standing. Making your student loan payments on time every month can help you build a good credit score, and you can keep track of your student loan’s affect on your credit by reviewing two of your credit scores for free every month on Credit.com. If you need help making your loan payments, don’t put off asking for it. One of your first steps should be to contact your student loan servicer and try to figure out a way to stay current on your loans.

More on Student Loans:

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Student Loan Borrowers Are Getting the Best Deal in 10 Years

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Here’s something you don’t hear every day: It’s a good time to be taking out student loans.

That’s because the interest rate on the most common student loans — undergraduate Federal Direct Loans — just dropped to 3.76% for loans disbursed between July 1 and June 30 of next year. Last year, the interest rate was 4.29%, and before that, it was 4.66%. Interest rates on federal student loans taken out by parents and graduate students also dropped, to 6.31% from 6.84%.

In 2013, a new student loan law tied federal student loan interest rates to the 10-year treasury note. President Barack Obama signed the law right before interest rates were set to jump to 6.8%, and now, every year, new student loan rates are set by the last 10-year treasury note auction before June 1. The rate is calculated by adding 2.05 percentage points to the high yield of the 10-year note at the time of the auction — 1.71% on May 11. (In writing the 2013 law, Congress added the 2.05 percentage points to cover the administrative costs of issuing these government-backed loans.)

Back in 2013, when this law was new, some student loan experts saw the move to a 10-year-note benchmark as a band-aid — that an improving economy would eventually drive up student loan interest rates to the high levels this method initially avoided.

“This interest rate can go pretty high,” Mitchell D. Weiss, a professor of finance at the University of Hartford, and a Credit.com contributor, said in a 2013 interview after Obama signed the law. Congress set a cap of 8.25% on undergraduate Direct loans and a 9.5% cap on graduate and parent PLUS loans.

That’s still the case but, for now, students taking out federal student loans in the coming academic year can enjoy their historically low interest rates. Between July 1, 2006 and June 30, 2010, Direct unsubsidized loans carried a 6.8% interest rate for undergraduate and graduate students. In the last decade, only borrowers who had Direct subsidized loans disbursed between July 1, 2011 and June 30, 2013 enjoyed an interest rate (3.4%) lower than the new 3.76%. (Subsidized loans, on which the government pays interest while the borrower is in school, are less common than unsubsidized loans.)

Of course, these lowest-in-a-decade interest rates may not be much consolation when considering that tuition increases have consistently outpaced inflation in the same time period. This interest-rate drop may not be as much of a good deal as it is a lucky break for students who will likely have record amounts of student loan debt. To see how your student loans affect your credit (they do, quite a bit), you can review your free credit report summary, updated monthly, on Credit.com.

More on Student Loans:

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