Paying Interest vs. Compounding During Moratorium: Which is the Smarter Choice?

Ever wondered how a simple decision during your loan's moratorium period could save you thousands? Paying interest during the moratorium vs. letting it compound can make all the difference in your financial future. When taking an education loan, borrowers often face the choice of paying interest during the moratorium or letting it compound but they often choose the latter considering paying during the moratorium can be a financial challenge. Let’s understand with the help of this blog which is better for you. 

What is Simple Interest?

Simple interest is a financial phrase that refers to a way of determining the interest charge on a loan. The interest is calculated just on the principal amount, or the original money borrowed, without compounding. This means that, regardless of the length of the loan term, the borrower is only charged interest on the amount initially borrowed. This computation approach is especially useful for students studying abroad since it makes the cost of borrowing more predictable and manageable.

The formula for calculating simple interest is:

Simple Interest (SI) = P × r × t

Where:

• 
  P is the principal amount (the initial loan amount),
• 
  r is the annual interest rate (expressed as a decimal),
• 
  t is the time period in years.

For example, if you take a loan of ₹1,00,000 at an annual interest rate of 10% for 3 years, the simple interest would be: 

SI = 1,00,000 × 0.10 × 3 = ₹30,000.

This means you will pay ₹30,000 as interest over the 3-year period.

What is Partial Simple Interest?

Partial Simple Interest in the context of education loans refers to the practice of paying a portion of the simple interest that accrues on the loan during the moratorium period, which encompasses both the time a student is in school and a grace period after graduation. Unlike full interest payments, in which interest is not compounded, partial simple interest payments add interest on interest to the principal amount but at a lower rate as the borrower is making some payments.. This option offers a middle ground for borrowers who want to minimize long-term loan costs but cannot afford to pay the full interest during the moratorium.

What is Compound Interest?

Compound interest is a financial method that is used to calculate the compounding of interest in case it is not paid for past payments. This is usually the time during the moratorium period when the borrower does not pay the interest and it gets added to the principal and the next month's interest is calculated on the compounded interest on the principal. This means that interest is compounded periodically, such as daily, monthly, or annually, leading to "interest on interest." Over time, compound interest can significantly increase the total repayment amount of a loan.

The formula for calculating compound interest is:

A = P × (1+nr)^nt

Where:

• 
  A is the amount of money accumulated after interest,
• 
  P is the principal amount,
• 
  r is the annual interest rate (in decimal),
• 
  n is the number of times the interest is compounded per year,
• 
  t is the time the money is invested or borrowed for, in years.

For example, if you take a loan of ₹1,00,000 at an annual interest rate of 10%, compounded annually for 3 years, the total amount (A) after 3 years would be:

A = 1,00,000 × (1+10.10)^1×3 = ₹1,33,100.

This means that over 3 years, ₹33,100 in interest would be added to the principal.

Impact of Paying Interest During Moratorium

Paying interest during the moratorium period can significantly reduce the long-term cost of a loan. When you pay interest during this phase, you prevent that interest from being added to the principal amount, which stops the "interest on interest" effect from taking place. This results in a smaller total loan balance and lower future EMI payments once the moratorium ends.

Let’s understand the same with the help of an example:

Assume you have taken a loan of ₹40,00,000 with a 12% annual interest rate and a 36-month moratorium period. A situational analysis can be found below where you are either paying interest or letting it compound. 

• 
  If interest is compounded during the moratorium, the borrower will pay a total of ₹79,85,224 by the end of the loan period, with an EMI of ₹92,919 after the moratorium.
• 
  If the borrower pays interest during the moratorium, they will pay a total of ₹77,42,431, with a lower EMI of ₹90,028.

This shows that by paying interest during the moratorium, the borrower saves ₹2,42,793 over the loan term. From the above analysis, the benefit that can be observed are -

• 
  Lower overall loan cost: Preventing the interest from being added to the principal reduces the total repayment amount.
• 
  Smaller EMIs: The EMIs after the moratorium period will be lower, easing future financial pressure.
• 
  No compound interest: Avoid the "interest on interest" effect that can significantly increase the total loan amount.
• 
  Improved financial planning: By paying off interest regularly, you can manage your loan better and avoid a large financial burden post-education.

In this way, you can have short-term and long-term financial benefits. It is easier to pay interest during the moratorium as the amount is less than that of your EMI which will start after moratorium. In case a borrower is unable to pay the full simple interest then some lender also offers partial simple interest payment options. This option involves paying a fixed amount, which will still lead to some compounding, but the effect will be much smaller compared to not paying any interest at all.

Repayment Options With Different Lenders

Below are different lenders and the repayment options they offer during the moratorium as per your application profile.

Deciding whether to pay simple or partial interest during a moratorium depends on your financial situation and goals. While paying interest during the moratorium can help reduce the total loan cost and future EMIs, it may not always be feasible for everyone. Borrowers who cannot make payments during the moratorium can explore other strategies, such as paying more than the minimum EMI or making partial foreclosures during the repayment period, to save money in the long run. The key is to evaluate your financial position and choose a repayment plan that best aligns with your needs. We understand that not everyone is a financial expert and this is where GyanDhan comes in. We can help you with your repayment and get you the best education loans. All you have to do is check your eligibility with GyanDhan.