A broad understanding of key financial topics can get you pretty far. For example, you don’t need to know everything about how interest works in order to choose a loan offer. But when you take the time to dive a little deeper, you can make a more informed borrowing decision and feel confident you’ve chosen the best loan for your situation.
Whether you take out a private student loan or a federal student loan, you’ll be charged interest on your loan until it’s repaid in full. Understanding how student loan interest works can help you know what to expect as you shop around for a loan or pay down your debt.
How federal student loan interest works
Federal student loans have fixed interest rates set by the U.S. government. These rates remain the same throughout the life of the loan. Besides having fixed rates, federal student loans have two different types of interest: subsidized interest and unsubsidized interest.
With a subsidized interest loan, the government pays the interest on your student loan while you are in school. This means the balance of your loan does not increase because interest isn’t accruing. Once you’re out of school, you’re responsible for paying the interest on the loan. Likewise, interest may also accrue during deferment or forbearance, both of which provide temporary relief from your student loan payments if you have an unexpected financial hiccup.
With an unsubsidized federal student loan, interest starts accruing from the day the loan is disbursed. Interest will accrue while you’re enrolled at school and will be added to the principal amount—or capitalized—after you graduate. It also accrues during deferment or forbearance. You can make interest-only payments during college to decrease the amount capitalized, which will lower your post-grad monthly payments.
How private student loan interest works
Unlike federal student loans, private student loans can have a variable interest rate or a fixed interest rate. A variable interest rate can change over the life of the loan, while a fixed interest rate won’t change. Note that lenders set their own rates and you might find these rates vary widely. Your lender will also consider your total debt, income, and credit score when determining your loan’s interest rate.
How to calculate interest on student loans
There are two formulas that lenders use for calculating interest on student loans: simple interest and compound interest. Here’s how simple interest is calculated.
- Look up your interest rate and divide it by 365 to find the daily interest rate.
- Then, multiply that figure by the current outstanding balance to find the daily interest dollar amount. For example, let’s say you have a $30,000 loan with a 6% interest rate. The daily interest rate is 0.000164, so the daily interest charged is $4.92.
- If you have a 30-day billing cycle, the total interest for that period is $147.60.
Note that all federal loans use a simple interest formula, but some private lenders may use a compound interest formula. If your lender charges compound interest, then the daily interest rate will be assessed on the unpaid principal as well as any unpaid interest. You’ll generally pay more in interest costs if the lender uses compound interest compared to simple interest. Here’s how compound interest works.
- If you have a $30,000 loan and 6% interest rate, the daily interest rate is 0.000164.
- On the first day of the billing cycle, you’ll be charged $4.92 in interest. Now, your balance is $30,004.92.
- On the second day, you’ll be assessed interest on the $30,004.92 and not just the $30,000 balance.
If you’re not sure which kind of formula your lender uses, you can call them and ask. Understanding how interest adds up can help you plan your student loan repayment strategy accordingly.
How interest affects your student loan payment
You’ll pay toward your loan’s principal and interest each month. Early in your loan term, you’ll pay a larger percentage toward interest because your principal balance is higher. As you continue to make payments on your student loan, your principal and the amount of accrued interest will decrease.
A higher student loan interest rate results in a higher monthly payment and more interest paid over the life of the loan. Likewise, refinancing to a longer student loan term also typically results in higher long-term interest costs, unless you can reduce your interest rate significantly.
How to pay less interest
Some lenders, including all federal loan servicers, provide a rate discount if you sign up for automatic payments. This only applies if you sign up directly through the lender’s website. Your bank’s automatic bill pay service does not count. Using automatic payments will ensure that you don’t make any late payments, which could hurt your credit score.
Deferment and forbearance may also increase the amount of interest you’ll owe because interest generally accrues during these periods. If possible, make interest-only payments to keep your interest costs manageable.
Refinancing your student loans could also reduce both the total and monthly interest paid. Here’s how it works. Let’s say you have a $50,000 loan with a 10% interest rate and a 10-year term. The monthly payment is $660.75. If you refinance with ELFI, you could earn a competitive interest rate based on your credit score, other debts, and income.
Contact ELFI to be paired with a loan advisor who can guide you through the refinancing process. They can help you understand your options, including the loan term you qualify for, and guide you on whether a fixed or variable interest rate is the right choice.
