Why Does Effective Annual Rate Matter?

It is common practice for lenders to state interest rates in annual percentage rate (APR). APR expresses how much interest you pay if interest was calculated on an annual basis (i.e. after 12 months), but this is not the case for most credit products. For example, interest on credit cards and student loans are calculated daily, even though you pay at the end of the month. For those that have student […]

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You are a newly minted, fresh grad ready for the adventures of adulthood and what your career will bring. You have your degree in one hand and your loan repayment agreement. Time to pay the piper.

As you read through your loan agreement for paying back your student loan, you stumbled across two words, “interest relief”…sweet. You mean the government will let me postpone making payments towards my student loans for a whole 6 months after graduation…how thoughtful. Without hesitation you put an X next to the box that says, ‘add the interest expense to the principal of my loan’ (I am paraphrasing). What’s a few hundred dollars going to do to the balance of my loan (you think to yourself)?

Six months later you get a whopping $1,601.50 (insert your amount here) of “interest relief” tacked onto the principle balance of your loan. Amortize that over 10 or more years that most students take to pay off their loan and the jokes on you.

This became my reality shortly after finishing my master’s degree. My interest expense after 6 months at 5.5% was around $1,610 and the amount for my husbands was $950…for 6 months! That’s almost $2,560…I think I missed the relief part.

I got curious the other day and decided to do some calculations to see how much this $2,560 of interest expense would morph into if I took 10 years to pay off my loan. Well, the amount doubled close to $5,200. Wow. Now you might say, well $5,200 over 10 years, that’s doable. But then again, what if interest rates go up? (interest rates in Canada are at a historical low so they have only one way to go, up), what if I need to extend my term even longer because, well…life happens? Suddenly, that $5k can morph into something even bigger. That’s the power of time and compound interest working against you.

The reality is, many of us will need to take out some amount of student loan to fund our post-secondary education. But we can be smart about it. When you graduate with government issued student loans and they give you the option to add the interest expense to your principal balance, please think twice. My suggestion would be not to. Pay it off from your savings, borrow from family, work a dead end job if you need to during the 6 months to cover the costs and then some.

 

Interest Relief is Costing You