In a perfect world, you’d make at least the monthly minimum payment on your student loans and slowly chip away at your balance while staying ahead of the game.
In reality, for recent college graduates burdened with student loan debt, nothing could be worse than fulfilling your monthly minimum payment -- only to find that your loan balance has increased the following month.
It’s called negative amortization: when your loan payments aren’t enough to pay the interest you owe or your principal.
In turn, that unpaid interest gets added to your total loan principal, making you owe even more money than you did last month!
Maintain this pattern, and after two or three months of minimum payments or just slightly more, you’ve started a vicious cycle of putting money towards your student loans that essentially counts for nothing, and now, you’re in deeper debt, even if only a few dollars at a time.
Here’s how to prevent your student loan balance from going up even when making your regular monthly payments.
Amortization vs. Negative Amortization
An amortized loan is one where regular monthly payments reduce the amount you owe.
More specifically, your monthly payment covers part of your loan principal, and part of it pays some of your interest.
Interest capitalizes -- meaning it accrues and builds upon itself from month to month -- and left unpaid, you run the risk of going into debt.
As with all such installment, non-revolving loans, a larger part of payments made early in an amortized loan’s life go to paying off interest first. Over time, your payments are applied more toward your principal.
With that, a negative amortizing loan is one where interest outpaces your monthly payments to the point that you’re not adequately covering it or your loan principal.
Your loan balance ends up growing and growing, and you’ll end up owing more than the loan is ultimately worth.
A loan on a regular amortization schedule would look something like this. Pulled from an online student loan calculator, this sample loan of $20,000 has a 10-year repayment schedule, a 6.8% interest rate (the current APR for undergraduate federal student loans), and a $230.16 full monthly payment:
Regular Amortization Schedule
|Month||Amount of payment to principal||Amount of payment to interest||Total interest paid||Remaining balance|
Look at the interest and principal from month to month.
Already after the first billing cycle has passed, you can see a larger portion of your monthly payment goes towards your principal, and less towards your interest -- even if it’s only about a dollar a month.
Assuming you make the full $230.16 payment each month, it’s enough to outpace interest accrual so it doesn’t get in the way of your principal.
But if you paid any less than that monthly expected payment, it becomes harder to pass that threshold from paying mostly interest to paying mostly principal.
And if you paid only the monthly minimum (for student loans, the average is $50 per month), or even less than the monthly minimum, you’ll never catch up with the rate that your interest is growing.
Unfortunately, that starts you off on a negative (instead of a positive) amortization schedule. Look at it as your interest rate overpowering your efforts, devouring your payments that have only served to create -- instead of cancel -- debt.
In the worst case negative amortization scenario, the remaining unpaid interest may get added to your principal, so not only do you still owe your original interest but interest on top of your existing principal.
Essentially, the lender is lending you the amount of unpaid interest, on which you'll pay interest.
Effect on cosigners: Not surprisingly, those who take out student loans often have cosigners on these loans -- usually parents or legal guardians. If you had a cosigner on your loan, negative amortization can hurt their credit and yours. Though you may be making regular loan repayments, if your debt is increasing, it’ll reflect on your credit report as outstanding, unpaid debt, something that can reflect poorly (and unfairly) on your cosigner’s credit record.
Why It Happens
These are the most common ways that negative amortization occurs with your student loan repayments:
Variable interest rates
The loan example we gave above is for a fixed-rate federal student loan, where your APR remains static for the life of the loan. A 6.8% interest rate when you take out your loan stays 6.8% throughout the life of the loan.
Variable, or adjustable rate loans (most often seen on mortgage loans) start off fixed for a certain period of time and then fluctuate either up or down according to market conditions.
They have just as much a chance to fall into negative amortization.
While it’s hard to argue if your interest rate drops a few decimal points from time to time, your student loan can still find itself negatively amortizing if your monthly payments don’t keep up with your current APR, no matter how high or low it is.
Special repayment programs
Income-driven, government-sponsored repayment plans, like PAYE or REPAYE benefit borrowers by capping out your monthly loan payments based on the amount of money you earn.
But beware -- once your payment is set according to your income, it still might not be enough to cover your loan’s interest -- never mind your principal -- creating a negatively amortizing situation that becomes harder and harder to escape.
How to Avoid Negative Amortization
Interest is arguably the most important thing to look at when it comes to paying off your loan since it can stand in the way of paying off the money you’ve borrowed.
Remember that amortization isn’t bad; it’s the process of paying down your loan and coming closer to a zero balance.
It’s negative amortization that sends your finances further in the other direction. Essentially, you’re paying just to get further into debt.
The key is to pay as much as you can toward your student loans, lower the interest you owe, and tackle your principal for the remainder of your loan. Here’s how to get started:
Make interest-only payments while still in school
One myth about student loans is that you don’t need to pay them off while you’re still in college (or that you’re not allowed to).
Pay as much as you can toward your loans’ interest, which will keep compounding even before you graduate.
That way, by the time you earn your degree and enter the world, you’ve paid off a sizable chunk of what you owe.
Seek deferment or forbearance
Deferment and forbearance are two ways to put your loans on hold after graduation.
Borrowers who opt for deferment have up to three years to begin paying off their loans, ample time to begin saving money to front-load your loan payments and tackle interest.
In some cases, such as Direct Subsidized Loans, the federal government may even pay your interest.
Forbearance is a pause in loan payments for up to one year to let you regroup financially, but beware -- interest still accrues during this time.
Tackle high-interest loans first
Deciding which student loan to pay off first can be a challenge if you have several to your name.
Interest is calculated according to your total loan balance, so give priority to loans with the highest balances and the highest interest rates.
Refine and retune your budget to free up extra cash to go toward your student loans. Use income tax returns, side hustle income, and other income generators as one strategy to make extra loan payments.
Refinance or consolidate your loans
Refinancing with your lenders, or consolidating your loans -- combining several loans into one new loan with a new APR -- are two additional methods of getting a lower interest rate, owing less interest, and making it easier to pay your interest and principal.
Request interest-only payments
Private lenders may be willing to arrange interest-only payments.
Instead of your payments being distributed across your interest and principal, they’ll go strictly to the interest you owe for as long as your arrangement is -- usually for a few months into the life of the loan.
Though this may make your loan(s) more expensive and lengthy down the road, it’ll at least tackle your interest to let you concentrate solely on your borrowed balance.
Remember that overpaying your student loans, such as doubling or tripling up your payment, doesn’t automatically go to paying your principal, but to your interest instead.
If averting negative amortization is your goal, then by all means, overpay if you can. But just like interest-only payments, if you wish to have principal-only payments, contact your lender so they know where to direct the money.
In the end, it’s your education, your student loans, your finances, and your life.
It’s important to shape and tailor the way you pay off your loans to the way that’s best for you -- not what others might tell you.
That’s not to say well-meaning advice (including this article) aren’t full of helpful tips that can set you on the right path; but everyone’s individual circumstances are different, so check in closely with your own to examine the best way to pay your loans, build your credit, avoid debt, and most of all, that you stood your own against amortization!