EXAMPLE 2 What Happens If You Don’t Make the Payments on the Principal?

After you begin to repay your federal direct student loan, what happens? The loan is capitalized, meaning that any unpaid interest accrued while you were in school and during the grace period is added to the principal and becomes the new balance on which interest is to be paid. That balance will decline as you amortize (pay off) the loan. You will be responsible for fixed monthly payments. The interest is calculated monthly, and the proportion of your payment going to interest will decline as you pay off the loan.

What if you do not make the payments due for the repayment? Well, the interest accrues and is capitalized every quarter into the principal: The interest is added to the loan balance (the amount owed), and interest for the next payment is calculated on the new loan balance. In other words, the compounding period is one quarter.

Suppose that six months after you graduate, when the grace period expires and you have to begin making payments, you owe $10,000 at 4.29% interest per year. However, you haven’t been able to find a job, so you fail to make any payments for the next year. How much would you owe then?

The principal is $10,000. The quarterly interest rate is and there are compounding periods. The compound interest formula gives the new amount owed as .

(It would be very foolish to just ignore the payments due, since after 270 days of nonpayment, the loan would be in default and all kinds of bad things would happen! Instead, you should contact the loan server about possible reduction or postponement of payments. Also, by executive order of President Obama, after December 2015 student loan repayments will be capped at 10% of the borrower’s monthly income.)