What Are Interest-Only Repayment Plans for Student Loans?

With student loan debt being such a burden on your finances, you might take steps to make repayment more manageable.

Now:

There are several ways to do this.

Income-driven repayment plans (including Income-Based Repayment and the Revised Pay as You Earn programs) are the popular options.

But:

An option you may not be as familiar with is interest-only repayment.

This type of payment plan can offer some unique benefits if you have federal loans.

If you're looking for another way to approach your loan debt, learn all about interest-only repayment to see if it is right for you.

Your Loans, Your Interest and You

Before getting to interest-only payment plans:

You have to understand how interest is applied to student loans.

So:

Every federal student loan must be repaid, with interest. Interest rates are set once per year by Congress.

Rates are fixed, meaning they won't change over the life of the loan.

You could, however, end up with a different rate if you refinance or consolidate your loans at some point.

The interest rate you pay depends on the type of loan you have and your enrollment status.

Interest accrues on Direct Loans daily. That means interest is added on to your principal loan balance.

Calculating accrued interest

The formula for calculating accrued interest is fairly straightforward. You multiply your loan balance by the number of days since you made your last payment.

Then, you multiply that by the interest rate factor.

To get your interest rate factor, divide your loan's interest rate by the number of days in the year.

When does interest accrue on federal student loans?

Technically:

Interest starts accruing on your loans the day they're disbursed.

Interest can accrue during grace periods, deferments and forbearance periods.

With subsidized loans, the federal government picks up the tab on the interest charges when you're enrolled in school at least half-time or still in your loan grace period. You don't get those benefits with unsubsidized loans.

During a forbearance period, you're responsible for paying all the interest that accrues on your loans.

With deferments, whether you're responsible for paying the interest depends on the type of loan you have.

This table illustrates when your responsibility for paying loan interest during a deferment period kicks in.

Interest Payments During Student Loan Deferment

If you're obligated to pay the interest on loans during a deferment or forbearance, you have two options.

First, you can pay the interest as it accrues. Or, you can allow the interest to be capitalized.

Capitalization means the accrued interest gets added on to your loan principal. This option is available only with Direct Loans and FFEL Program loans.

Once you're ready to make payments to your loans, the balance owed may be higher.

Depending on how long interest was allowed to accrue and the amount you borrowed, you could wind up with significantly more debt.

How Interest-Only Repayment Plans Work

An interest-only repayment plan is different from standard or even income-driven repayment plans.

Instead of making payments towards your student loan principal, you make payments towards the interest that's accruing.

You may have the option to make interest-only payments while you're still in school, or during your six-month grace period after graduation.

Note:

You can also make interest-only payments during a deferment or forbearance.

If you're on a standard repayment plan or income-driven plan, you'd be responsible for making your regular monthly payment.

Pros

Making payments against your interest can yield some benefits.

Here's what you could gain by making interest-only payments:

1. You could save money on interest.

When it comes to repaying your loans, every penny saved counts.

When you make interest-only payments, you can trim a few dollars off the interest total.

Consider this example.

Say you have $30,000 in Direct Subsidized Loans at 5.05 percent.

You defer your loans for 12 months, with interest capitalized quarterly. You opt for a standard 10-year repayment plan once your deferment period ends.

If you allow the interest to capitalize on your loans during the deferment period you'd accrue $1,543.93 in interest charges.

That would be added on to the $8,696.87 that would accrue over the life of the loan.

Making interest-only payments during the deferment period would reduce the interest charges to $1,515 and $8,271.60 respectively.

By making those payments, you'd save $454.20 over the life of the loan. That's not a huge amount but it's still money saved.

2. You may reduce the chances of defaulting on your loans.

For most people, repaying student loans is something that happens over a period of years.

Making interest-only payments while still in school, during the grace period or on deferment can help ingrain the habit.

When you're used to making payments towards your loans, you may be less likely to default.

Generally, you're considered to be in default when you've missed payments on your loans for nine consecutive months.

Defaulting on federal student loans is a bad idea for a few reasons.

First, it can do serious damage to your credit score.

Payment history carries the most weight in credit score calculations. Having multiple late payments show up on your credit report can eat away at your score.

A low score can make it harder to get approved for credit cards or loans, including a mortgage.

Defaulting can also put your tax refund and your income at risk.

The federal government can claim your tax refund or any other federal benefits you're entitled to and use them to repay defaulted loans. Your wages could also be garnished and used to repay your loans.

Your school can also get involved.

Your transcripts could be withheld until you've brought your loans out of default. That could be an obstacle if you're trying to get into a graduate or professional program, or a prospective employer asks to see a copy of your academic records.

Cons of Making Interest-Only Payments

While there are some good reasons to consider making interest-only payments, it does have potential downsides:

1. It doesn't affect your loan principal.

Making interest-only payments can save you a few dollars on interest but you still have the remaining loan balance to contend with eventually.

Even though you might be in the habit of paying towards your loans, you could be in for a reality check once it's time to pay on the principal.

Still:

Taking time to learn what your loan payments will be once a deferment, forbearance or grace period ends can help.

Depending on your income, you may be able to work your way up and pay more towards your loans during an interest-only period.

That can chip away at your balance and prepare you for when your regular payments begin.

2. It might make more sense to save money instead.

If you're fresh out of college, you may not be earning a lot yet. And, you may be just getting started with savings.

That could work against you if a financial emergency comes along. Even something small like a flat tire could throw your finances out of whack.

Taking the money that you would have paid towards the interest on your loans and putting in a high-yield savings account instead can give you some insulation against emergencies.

That way, you don't have to use a credit card or another loan to pay for unexpected costs.

What you should do:

Weigh the amount of interest that could accrue against the interest you could earn on your savings.

If you can get a great rate on savings, it may be worth it to build up your emergency reserves first, then focus on making interest-only payments to your loans.

Should You Use an Interest-Only Repayment Plan?

Whether an interest-only repayment plan is right for you depends on:

• Your total loan balance
• Your loan interest rate
• The type of loan you have
• What you can afford to pay towards your loans
• Whether you have any money tucked away in savings

If you have a little bit of emergency cash set aside and you can afford to make interest-only payments, it could be a smart move.

That's especially true if you have a larger loan balance and want to eliminate some interest.

But, if you only owe a smaller amount in loans and you don't have any money for rainy days, you may want to focus on saving first.