How Does Student Loan Interest Work?
What is student loan interest?
To better understand how interest on a student loan works, let’s start by defining what “interest” means.
Interest on a loan of any kind – college, car, mortgage, etc. – is, essentially, what it costs to borrow money. It is calculated as a percentage of the principal (the amount you borrow), and this percentage is what’s known as your interest rate.
How interest works when paying back student loans
Student loan interest rates can be fixed (unchanging for the life of the loan) or variable (fluctuating throughout the life of the loan). In both cases, the lower the interest rate, the less you’ll owe on top of the principal, which can make a big difference in the total amount you’ll owe on your loan over time.
A student loan is often a long-term commitment, so it’s important to review all of the terms of your credit agreement (sometimes called a promissory note) before signing. This note is just how it sounds – an agreement or promise you make to pay back your loan within the parameters laid out by your lender.
Terms in a credit agreement include:
- Amount borrowed
- Interest rate
- How interest accrues (daily vs. monthly)
- First payment due date
- Payment schedule (how many payments – or “installments” – it will take to pay back the loan in full)
Your student loan will not be considered repaid in full until you pay back both the principal and the interest. To better understand how these costs combine, let’s dive into some common questions about student loan interest.
How Are Student Loan Interest Rates Calculated?
Your interest rate is determined by your lender. In most cases, if you’re considered a riskier candidate (and many students are, simply because they lack credit histories and steady incomes), the loan can be more expensive by way of a higher interest rate. To help secure a lower interest rate, students often apply with a co-signer.
This applies more to private student loans than federal student loans, which have a separate application process that does not always consider the credit worthiness of applicants.
How is interest calculated on federal student loans?
Federal student loans, which are issued by the government, have a fixed interest rate (unchanging for the life of the loan), which is determined at the start of the school year. The rate determination is set in law by Congress.
Federal student loans and simple daily interest
Federal student loans adhere to a simple daily interest formula, which calculates interest on the loan on a daily basis (as opposed to monthly).
Since federal student loans are issued annually, it’s fairly simple to calculate the amount of interest you’ll owe that year. Just take your annual loan amount (the principal), multiply it by your fixed interest rate, then divide that amount by 365:
Principal x Interest Rate / 365Example:$5000 x 5% / 365 = 0.68 (68 cents per day will accrue on this loan)
With these stabilized variables, interest on federal student loans can be easier to predict than interest on private student loans. However, since both types of loans might be required to cover costs, it’s a good idea to understand how interest works on both.
How is interest calculated on private student loans?
Private student loans, which are issued by banks, credit unions, and other non-government entities, can have either fixed or variable interest rates, which can fluctuate during the life of a loan. Private loans also may have compound interest.
Student loans and compounded interest
The student loan compound interest formula differs from the simple daily interest formula.
When interest is compounded, it gets added to the principal each month. Interest is then calculated on that new principal amount to determine interest accrued for the following month.
If you’re thinking, “Wait. That sounds like interest getting charged on interest,” you are correct. And since the process repeats itself each month, paying more than the minimum due can help you stay ahead of this added expense.
Variable vs. Fixed Student Loan Interest Rates
When shopping for student loans, you might find that some variable interest rates are lower than the fixed federal student loan interest rate. But there are advantages to having a stabilized rate. Consider that if the life span of your loan is 15 or 20 years, a lot can happen to interest rates in that time. This makes it difficult to predict monthly loan payments.
Because of this, many lenders provide a cap on variable interest rates (or assign a fixed margin) to assure that even in the most volatile markets, your interest rate and loan bills won’t skyrocket.
For a more detailed look at how variable and fixed interest rates differ, see: Variable vs. Fixed Interest Rates: What’s the difference?
When Do Student Loans Start Accruing Interest?
Most lenders understand that full-time students don’t usually have full-time incomes, so many student loans do not require payments while you’re still in school. However, interest on these loans will begin accruing during that time.
Do unsubsidized loans accrue interest while you’re in school?
Both subsidized and unsubsidized federal student loans accrue interest while you’re in school, starting at your loan disbursement date. However, there is an important difference between the two:
- With subsidized federal loans, the government assumes responsibility for interest accrued while you’re in school (so long as you maintain full-time student status).
- With unsubsidized federal loans, you are responsible for paying all the interest accrued on your loan.
However, because unsubsidized federal student loans do not capitalize until after you graduate (or at any time your student status changes to less than half-time), there is a way to save some money when paying down this loan.
What is capitalized interest on a student loan and why does it matter?
Capitalization happens when interest accrued gets added to your principal. With unsubsidized federal student loans, the amount of interest accrued on the loan while you’re still in school will not be added to your principal until after graduation (or upon a student status change).
This might not seem like much of a benefit since you will still have to pay that money, but consider that if you make any payments on your loan before it capitalizes, those payments will be interest-free and apply exclusively to reducing your principal.
For this reason, students greatly benefit from in-school loan payments. In-school payments reduce the total amount you’ll be paying in accrued interest on your student loan and – as a result – the total cost of that loan over time.
How To Make Interest Payments On Student Loans
When it comes to paying interest on student loans, two things remain true:
- Timing is everything!
- More is more!
First and foremost, it’s important to stay on schedule with your monthly payments, covering at least the minimum amount due so that you don’t default on your loan.
Since the accruement of interest can make loans expensive over time, it’s wise to pay more than the minimum due and/or make loan payments while you’re still in school. Amounts as low as $25 dollars a month while you’re in school can make a difference. For more information, explore The Benefits Of In-School Student Loan Payments.
When applying for student loans, it is recommended that you exhaust federal student loan options before moving on to private student loans, but it is entirely possible that both will be necessary to cover your costs. With that in mind, see if you can find a private student loan with a competitive interest rate.
Understanding how interest works when paying back student loans can go a long way in helping you keep the costs of borrowing money down – on student loans or any other type of loan you might take out in the future.
Learn more and plan ahead with the following resources: