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Many student loan programs let borrowers skip making payments while the student is in school and for six months after graduation. The lender still charges interest on the loan during the in-school deferment, but the unpaid interest is added to the loan balance, causing the loan to get bigger. This leads to a larger monthly loan payment when the borrower begins repaying the loan. Effectively the borrower will be paying interest on interest, yielding a much more expensive loan that will take longer to repay. Borrowers who make partial monthly payments during the in-school deferment will save a lot of money over the life of the loan as compared with borrowers who don't make any payments. Ideally borrowers should make payments of at least the new interest that accumulates each month during the in-school and grace periods.

Definitions

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The following definitions will help clarify the discussion of the benefits of making payments on a loan during the in-school deferment period.

• Principal: The principal balance on a loan is the amount of money borrowed.
• Loan Balance: The loan balance is the amount of money still owed on the loan.
• Interest: Interest is a periodic fee charged to the borrower for the loan. The interest is usually expressed as a percentage of the current loan balance.
• Interest Capitalization: If the borrower does not pay the interest as it accrues, the interest is capitalized. This adds the interest to the loan balance, increasing the amount owed.
• Accrue: Accrual refers to amounts, such as interest or other fees, that accumulate or are charged during a period of time and which are not paid by the end of the period.
• Deferment: A deferment is a period of time during which payments are not required. Interest, however, continues to accrue on unsubsidized loans during a deferment and will be capitalized if not paid. The interest on a subsidized loan is paid by the government during a deferment.
• Forbearance: A forbearance is a period of time during which payments are not required. Interest, however, continues to accrue on both subsidized and unsubsidized loans during a forbearance and will be capitalized if not paid.
• Subsidized Loan: With a subsidized loan, the government pays the interest on the loan during an authorized deferment, such as the in-school deferment or the economic hardship deferment. The Federal Perkins and Federal Subsidized Stafford loans are examples of subsidized student loans.
• Unsubsidized Loan: With an unsubsidized loan, the interest continues to accrue during a deferment period and is not paid by the government. The Federal Unsubsidized Stafford and Federal PLUS loans are examples of unsubsidized education loans.
• Negative Amortization: Negative amortization occurs when the payments on a loan are less than the interest that accrues, causing the balance owed on the loan to increase. Interest capitalization is a form of negative amortization.

The Problem with Negative Amortization

Deferring repayment can help a borrower by shifting the repayment obligation from a period during which the borrower can't afford to make payments to one in which the borrower's finances have improved. However, this benefit comes at a significant cost. During the deferment any accrued but unpaid interest is capitalized by adding it to the loan balance. The capitalized interest causes the size of the loan to increase, leading to much larger monthly payments after the deferment is over. If the borrower's ability to repay the loan hasn't improved, this can make a bad situation worse because the monthly payments will be even less affordable after the deferment.

Deferments are only advisable when the borrower's financial difficulty is short-term, such as temporary unemployment. Longer-term deferments are more problematic. The longer the deferment, the more the debt grows. Deferments are also not a good solution when the borrower's finances are unlikely to improve during the deferment.

It is much better to make payments, even small ones, during a deferment period. Ideally these payments should be at least the new interest that accrues. This will prevent the debt from growing larger during the deferment. Interest-only payments on a Federal unsubsidized Stafford loan will typically be about half the full monthly payments on a 10-year term. Interest-only payments, however, are not a permanent solution, as such payments will make no progress in retiring the debt.

Increasing the term of the loan is another way of reducing the monthly payments. For example, increasing the term on a Federal unsubsidized Stafford loan from 10 years to 20 years will cut the monthly payment by about a third (34%). But because the payments exceed the new interest that accrues, the borrower will make some progress in retiring the debt.

Of course, the less you pay per month, the longer the repayment term and the higher the cost of the loan, because a longer repayment term increases the total cost of the loan. For example, increasing the term on a Federal unsubsidized Stafford loan from 10 years to 20 years will more than double the interest paid over the life of the loan, increasing it by a factor of 2.18.

In-School Deferment Inflates the Loan Balance

A dependent student can borrow $5,500 in Federal unsubsidized Stafford loans during the freshman year in college, $6,500 during the sophomore year, $7,500 during the junior year and $7,500 during the senior year, for a total of $27,000. An independent student can borrow $4,000 more per year during the freshman and sophomore years and $5,000 more per year during the junior and senior years, for a total of $45,000. (The aggregate limits of $31,000 and $57,500 for dependent and independent students, respectively, are higher because the aggregate limits allow for more than four years to complete a Bachelor's degree.) The interest rate on the Federal unsubsidized Stafford loan is 6.8%.

Let's assume that each year's loans are disbursed in two equal installments, one in September at the start of the fall semester and one in January at the start of the spring semester. Let's also assume that the student defers repaying the loan during the in-school period and the 6-month grace period, with the accrued but unpaid interest capitalized monthly. Let's ignore any origination and default fees, which are usually deducted from the disbursements.

Then a dependent student who borrows the maximum amount of Federal unsubsidized Stafford loans will have a loan balance of $31,978 upon entering repayment at the end of the grace period. This is $4,978 (18.4%) higher than the $27,000 borrowed. The monthly payments under a 10-year repayment term will be $368 instead of $311 ($57 higher) and the total payments over the life of the loan will be $2,369 higher as compared with a borrower who pays the interest during the in-school and grace periods. That's 8.8% of the amount originally borrowed. On a 20-year term the total payments are $4,614 higher and on a 30-year term the total payments are $7,177 higher.

An independent student who borrows the maximum amount of Federal unsubsidized Stafford loans will have a balance of $53,325 upon entering repayment at the end of the grace period. This is $8,325 (18.5%) higher than the $45,000 borrowed. The monthly payments under a 10-year repayment term will be $614 instead of $518 ($96 higher) and the total payments over the life of the loan will be $3,966 higher as compared with a borrower who pays the interest during the in-school and grace periods. That's 8.8% of the amount originally borrowed. On a 20-year term the total payments are $7,721 higher and on a 30-year term the total payments are $12,007 higher.

Thus deferring the interest during the in-school and grace period increases the loan balance at repayment by about 18.5% and the total payments over the life of a 10-year loan by 8.8% of the amount originally borrowed. On a 20-year term the total payments increase by 17.2% of the amount originally borrowed and on a 30-year term the total payments increase by 26.7% of the amount originally borrowed.

On Federal PLUS loans and private student loans the added cost of deferring the interest is even higher due to the higher interest rates.

How to Avoid Negative Amortization

The best solution is to make payments of at least the new interest that accrues during the in-school and grace periods. Although interest-only payments are not as good as making full payments of principal and interest, interest-only payments are better than deferring payments of both the principal and interest. Payments that are at least the new interest that accrues will prevent the loan balance from getting bigger.

There are no prepayment penalties on federal and private student loans, so you can make interest-only payments during the in-school deferment and grace periods on any student loan, even if the lender does not require in-school payments or have a formal interest-only payment option. It is best to include a note with the payment asking for the payment to be applied to the principal balance of the loan. Also, if you have both subsidized and unsubsidized student loans, you should specify that the extra payment should be applied to the unsubsidized loans.

Some lenders offer loan programs in which payments are required during the in-school and grace periods. For example, Sallie Mae's Smart Option Private Student Loan requires borrowers to make payments of at least the interest or $25 a month on each loan. Since the balance at graduation is lower, the Smart Option loan can use a shorter repayment term without increasing the monthly payment too much as compared with a loan that defered payments of principal and interest during the in-school period. Borrowers of the Smart Option loan will save a lot of interest and pay off their loans sooner than borrowers that do not make payments during the in-school period. Several of the state loan programs also require interest-only payments during the in-school and grace periods.