How Student Loan Interest Works
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By Joe Arns

January 22, 2019

Like almost all loans, student loans charge interest. But how does student loan interest work? 

Unfortunately, it’s not as straightforward as you might hope. 

But, understanding how it works is vital to making sure you know how much you’ll have to pay back on your federal student loan or private student loan.

Interest is a fee charged by a lender for using borrowed money. 

Student loan interest can vary based on if your loan is a subsidized loan or unsubsidized loan, a federal loan, or a private loan.

This article will walk you through how student loan interest works for each type of loan and situation.

Use our Student Loan Calculator to determine the monthly loan payment and total payments on your student loans.

Simple Interest and Compound Interest

Interest is the amount of money due to a lender for providing funds. It’s typically expressed as an annual percentage of the loan balance.

The interest a borrower pays may be simple or compounded.

How Simple Interest Works

Simple interest is charged based on the principal balance of a loan (the amount you originally borrowed).

For example, if the balance on a student loan is $10,000 and the annual student loan interest rate is 5%, the simple interest due after one year is $500 ($10,000 x 0.05).

How Compound Interest Works

Compound interest is charged based on the overall loan balance, including both principal and accrued but unpaid interest (interest charged to the loan and not yet paid). 

So, compound interest involves charging interest on interest. If the interest isn’t paid as it accrues, it can be capitalized, or added to the balance of the loan. 

For example, if the loan balance starts at $10,000 and the interest due after one year is capitalized, the new loan balance becomes $10,500 ($10,000 + $500) and the interest accrued in year two is $525 ($10,500 x 0.05).

 

How Interest Accrues on Student Loans and Parent Loans

Interest on student loans and parent loans (PLUS loans) is charged daily. To calculate the interest accrued, lenders use the following formula:

Interest = Loan Balance x (Annual Interest Rate / Number of Days in Year) x Days in Accrual Period

Subsidized and Unsubsidized Loans

A direct student loan (a loan made by the US Department of Education to the student loan borrower) can be subsidized or unsubsidized. 

A subsidized loan has interest advantages and is available to a student (federal student loan borrower) showing financial need. 

An unsubsidized federal student loan is a student loan without the adjustments for financial need.

Subsidized Direct Student Loan Interest

Subsidized Federal Direct Stafford loans don’t accrue interest while the student is in school or during the six-month grace period after the student graduates or drops below half-time enrollment. 

Technically, subsidized loans do accrue interest, but the interest is paid for the student loan borrower by the federal government. 

The government pays interest that accrues during the time the borrower is in-school and grace periods, as well as other periods of authorized deferment (a period where your student loan payment is temporarily paused).

Unsubsidized Direct Student Loan Interest

Unsubsidized Federal Direct Stafford Loans, as well as all other student loans and parent loans (such as direct PLUS loans) begin accruing interest as soon as the loan proceeds are disbursed.

Capitalization

When a student loan enters repayment, all accrued but unpaid interest is capitalized (added to the loan balance — your student loan debt). The monthly student loan payment due during repayment is based upon the new loan balance. 

The interest on private student non-federal loans may be capitalized more often during the in-school and grace periods. Some loans even capitalize interest as often as monthly. 

Contact your lender or loan servicer (the company that collects the payments) for details on how the interest is capitalized on your private student loan.

For example, if the original loan balance is $10,000, the interest rate is 5%, and no payments are required during the 45-month in-school period and the six-month grace period that follows, the amount of accrued interest when the repayment period begins is approximately:

$10,000 x (0.05 / 365 days) x 1,551 days = $2,125

So, the loan balance when repayment begins is $12,125 ($10,000 + $2,125). The interest has added $2,125 to your student loan debt.

Interest Accrues Even During Periods of Non-Payment

Most student loans, especially federal student loans, don’t require payments while the student is enrolled in school on at least a half-time basis and during a grace period after enrollment ends.

However, interest starts accruing for many loans as soon as the money is disbursed, even before you begin making payments.

Interest continues to accrue (be charged) on a student loan even when the student loan borrower isn’t making payments on the loan. So, if the student loan borrower is in a deferment or forbearance interest can still rack up. 

Interest continues to be charged even under income-driven repayment plans if you have an eligible loan in that program. Likewise, if the borrower is late with a payment or in default, interest will continue to be charged.

Graphic showing types of income driven repayment plans for student loans

(Image Source

Deferment and Forbearance

Deferment and forbearance both mean that your student loan payments are paused for a certain length of time. 

If the student loan borrower isn’t making payments because the loan is in deferment or forbearance, interest continues to accrue and is later capitalized when repayment resumes. For example, if interest isn’t paid while the student is in school, the interest is added to the loan balance when repayment begins.

Income-Driven Repayment Plans and Negative Amortization

All of the federal student loan income-driven repayment plan options allow for negative amortization. Negative amortization is where the monthly student loan payment isn’t enough to cover the cost of new interest being accrued (charged) on the loan. 

Income-based repayment plan (IBR), Income-contingent repayment plan (ICR), Pay-as-you-earn repayment plan (PAYE), and Revised-pay-as you-earn repayment plan (REPAY) all allow this situation to occur.

If a repayment plan is negatively amortized, the monthly payment might be less than the new interest that accrued since the last payment. In that case, the loan balance will increase even as you make your payments, unless your loan is subsidized.

Subsidized Loan Exception

The only exception is for subsidized loans, where the federal government pays the interest as it accrues during the in-school and grace periods and during periods of authorized deferment.

So long as the borrower makes the required monthly payment, which exceeds the new interest, the interest due each month will be covered and the loan balance won’t continue to grow.

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How Loan Payments are Applied to Principal and Interest

Monthly student loan payments include both interest and principal, like almost all loans. The monthly payments are applied first to late fees and collection charges, second to the new interest that’s been charged since the last payment, and finally to the principal balance of the loan.

As the loan balance declines with each payment, so does the amount of interest due. If monthly payments are level, or a fixed amount, the principal balance declines faster with each successive payment — at least if your monthly payment is greater than the interest charged each month.

When a student loan borrower sends in a payment to their lender, the payment is applied to the principal balance only after it is applied to the interest. 

If a borrower sends in more than the scheduled payment each month, the excess is usually applied to the principal balance, leading to the loan balance decreasing faster and faster each month. However, you should confirm with your lender on where an extra payment will go. Some lenders will apply it to a future payment. 

Making extra payments will lead to the loan being paid off before the scheduled repayment term ends, effectively shortening the life of the loan and the total amount of interest paid.

Loan Payment Walkthrough Example

For example, let’s assume a borrower has a $10,000 loan balance at the beginning of repayment with an interest rate of 5% and a 10-year level repayment schedule. 

They would make payments of $106.07 per month and pay $2,727.70 in total interest over the life of the loan. For the first month, the payment would be applied as follows:

$41.67 to interest ($10,000 x 0.05 / 12)

$64.40 to principal ($106.07 – $41.67)

But, if the borrower sends in $188.71 the first month, a greater proportion of the payment would be applied to reduce the loan balance:

$41.67 to interest ($10,000 x 0.05 / 12)

$147.04 to principal ($188.71 – $41.67)

If the borrower continues making monthly payments of $188.71, the loan will be paid off in only five years with a total interest of $1,322.76.

How to Reduce the Total Interest Paid on Your Student Loans

There are several ways a borrower can reduce the total interest paid on their student loans:

  • Make interest payments during the in-school and grace periods
  • Choose a shorter repayment term
  • Make extra payments to speed up loan repayment after graduation
  • Refinance at a lower interest rate
  • Consider PSLF (public service loan forgiveness)

Make Interest Payments Early

Paying the interest as it accrues each month while you are still in school and during the six-month grace period will keep the loan balance from increasing. When the repayment period begins, there will be no unpaid interest to be capitalized, and the required monthly payment should be lower.

Opt for a Shorter Repayment Term

A shorter repayment period always results in less total interest paid over the life of the loan. The standard repayment term is 10 years for Federal Direct Loans, but borrowers may be eligible to choose repayment terms as long as 30 years. The repayment periods for private loans vary and are set at the time the promissory note is signed.

Make Extra Payments

There are no prepayment penalties on student loans. Lack of penalty allows borrowers to make extra payments on their student loans without having to pay any extra fees. 

Making extra payments reduces the loan balance, so that more of each payment is applied to the principal than to interest. It also pays off the loan quicker, reducing the total interest paid over the life of the loans.

The ChangEd app could help you pay extra on your student loans. The app links to your student loans – both federal and private – and puts extra money towards your student loan balance. It rounds up your purchases, and applies that “spare change” to your student loan. Read our full review to learn how it works.

Refinancing

The total amount of interest paid may be reduced by refinancing the loan at a lower interest rate. The federal government offers loan consolidation, which doesn’t reduce the average interest rate on a borrower’s student loans. 

But there are many lenders who will refinance private student loans. If the credit scores of the student loan borrower and cosigner (if applicable) have improved, the borrower might be able to qualify for a lower interest rate on a private student loan refinance.

Refinancing federal student loans into a private student loan isn’t always recommended, as the borrower will lose access to the superior repayment benefits on federal student loans. For example, income-driven repayment plans, generous deferment options, and potential loan forgiveness after a set number of payments.

Before refinancing federal student loans into a private student loan, the borrower should weigh the potential need for an income-driven repayment plan or desire to apply for loan forgiveness. These options aren’t available with private student loans. 

The fixed interest rates on federal student loans are also generally lower than the fixed interest rates on most private student loans.




PSLF (Public Service Loan Forgiveness)

Federal student loans in the direct student loan program are generally eligible for the Public service loan forgiveness (PSLF) program. Direct PLUS loans are usually also eligible. PSLF forgives or reduces debt on student loans after the student loan borrower has made at least 120 payments, if the borrower works in a qualified public service job.

Decrease the Interest Charged on Interest as Much as Possible

Most student loan borrowers don’t have the income to make interest payments while they are in school. But, once student loan repayment begins, borrowers should try to avoid missing payments or applying for a deferment or forbearance. 

The unpaid interest would need to be paid back, along with interest charged on the interest. Conversely, speeding up student loan repayment after graduation decreases the total interest charged on the interest that accrued during the in-school and grace periods.

Sign up for Automatic Payments

Many lenders will give you a small interest rate deduction if you sign up for automatic payments. This means that each month, your payment is automatically deducted from your bank account. 

If you are confident you would have the funds to cover the monthly payment, this could also help you avoid late payments and any fees that go along with that.

Conclusion 

Student loans can have a repayment term (how long it takes to pay it off) that lasts for decades. 

Sometimes, your payment may not even cover all of the interest charged on your loan each month. Understanding how student loan interest works is vital to starting your financial life after college in a healthy way.

Now that you have a good handle on how student loan interest works for the different types of loans, repayment plans, and deferment situations, you’re ready to start looking at figuring out student loan payments and plans for you.

You can use our Student Loan Calculator to determine the monthly loan payment and total payments on your student loans.

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