How Does Interest Accrue on Student Loans?May 18, 2021
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 the best loan or refinancing offer for your situation.
But when you take the time to dive a little deeper, you start to feel more secure in every decision you make. Understanding the “why” of student loan interest will make you a more confident borrower – and you might be surprised at how quickly it all starts to make sense.
How Interest Accrues on Student Loans
Private and federal loans handle interest differently. Here are the key differences:
Federal Student Loans
There are two types of federal student loans: subsidized and unsubsidized. Only students with a demonstrated financial need qualify for subsidized loans, which do not accrue interest while you’re in school or during deferment.
Students who are not eligible for subsidized loans can take out unsubsidized loans, which do accrue interest during in-school and deferment periods. Interest will accrue while you’re enrolled and will be added to the principal amount after you graduate. This process is also known as capitalization. Students can make interest-only payments during college to decrease the amount capitalized, which will lower their post-grad monthly payments.
Deferring your student loans several times could inflate the balance, along with the total interest you owe. That’s why you should only defer loans when you absolutely can’t afford your loan payments or are at risk of missing a rent, mortgage or other payment.
Private Student Loans
Interest starts to accrue on private student loans as soon as the loan is disbursed. Private lenders will still charge interest while you’re in school and during forbearance periods. Interest will likely be capitalized during these times, but it depends on the specific lender.
How to Calculate Interest on Student Loans
There are two ways that lenders can charge 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.
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. Knowing which type of formula your lender uses can help you plan your student loan repayment strategy ahead of time.
How Interest Affects Your Student Loan Payment
The interest rate is one of the most important factors in determining how much your student loans will actually cost you. A higher student loan interest rate results in a higher monthly payment and more interest paid over the life of the loan – so if you can find a way to lower your interest rate, you’ll pay less interest over that time.
There are two types of interest rates, fixed and variable. A fixed interest rate will remain the same for the entire term, unless you refinance. A loan with a variable interest rate comes with a predetermined range of interest rates. At any point during the loan term, the interest rate could fall or rise within that range.
For example, let’s say you have a loan with a variable interest rate between 2% and 5%. Your interest rate could be as high as 5% or as low as 2%. Variable interest rates change depending on the general market. If overall market rates decrease like they did during the Covid-19 pandemic, then the lender could lower your rates. If the market rates go up, your rate will increase too.
The interest on a variable-rate loan may change as often as every month, depending on the loan servicer. Federal student loans only offer fixed interest rates, while private loans can have either fixed or variable interest rates. Call your private lender or log into your account to see what type of interest you have.
How to Pay Less Interest
Some student loan companies, 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 also harm your credit score.
Deferment and forbearance periods may also increase the amount of interest you’ll owe, because interest will accrue and be capitalized when these periods end. If possible, make interest-only payments during deferment to decrease the amount capitalized.
If you can afford to pay extra on your student loans, then the overall principal balance will decrease faster and save you money on interest.
Refinancing your student loans can 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 personal 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 the fixed and variable interest rates.