How Does Student Loan Interest Work?August 3, 2019
When you take out a student loan, you will not just be paying back the amount you borrowed – the lender will also charge you interest. The easiest way to think of interest is that it’s the cost paid by you to borrow money. Whether you take out a private student loan or a federal student loan, you will be charged interest on your loan until it is repaid in full. So, when you have finished paying off your loan, you will have paid back the original sum you borrowed (your original principal), plus you will have paid a percentage of the amount you owed (interest). Properly understanding the way that student loan interest affects your loan is imperative for you to be able to manage your debt effectively.
The Promissory Note
When a student loan is issued, the borrower agrees to the terms of the loan by signing a document called a promissory note. These terms include:
- Disbursement date: The date the funds are issued to you and interest begins to accrue.
- Amount borrowed: The total dollar amount borrowed on the loan.
- Interest rate: How much the loan will cost you.
- How interest accrues: Interest may be charged on a daily or monthly basis.
- First payment date: The date when you are expected to make your first loan payment.
- Payment schedule: When you are required to make payment and how many payments you have to make.
How Different Types of Student Loans are Affected by Interest Rates
- Government-Subsidized loan: If you are the recipient of a government-subsidized direct loan, the government will pay your interest while you are in school. This means that your loan balance will not increase. After graduation, the interest becomes your responsibility.
- Parent PLUS Loan: There are no government-subsidized loans for parents, and regular repayments are scheduled to begin 60 days after the loan is disbursed.
- Unsubsidized Loan: The majority of students will have unsubsidized loans where interest is charged from day one. If you have this type of loan, sometimes a lender will not require you to make payments while you are still in school. However, the interest will accrue, and when you graduate you’ll find yourself with a loan balance higher than the one you started with. This is known as capitalization.
Here’s an example: In your freshman year, you borrow $7,000 at 3.85%. By the time you graduate in four years, this will have grown to $8,078 – an increase of $1,078. Here’s the math: 7,000 × 0.0385 × 4 = $1,078 (Check out ELFI’s student loan repayment calculator.)
How is Student Loan Interest Calculated?
When you begin to make loan payments, the amount you pay is made up of the amount you borrowed (the principal) and interest payments. When you make a payment, interest is paid first. The remainder of your payment is applied to your principal balance and reduces it.
Let’s suppose you borrow $10,000 with a 7% annual interest rate and a 10-year term. Using ELFI’s student loan payment calculator, we can estimate your monthly payment at $116 and the interest you will pay over the life of the loan at $3,933. Here’s how to determine how much of your monthly payment of $116 is made up of interest.
1. Calculate your daily interest rate (also known as your interest rate factor). Divide your interest rate by 365 (the number of days in the year).
.07/365 = 0.00019, or 0.019%
2. Calculate the amount of interest your loan accrues each day. Multiply your outstanding loan balance by your daily interest rate.
$10,000 x 0.00019 = $1.90
3. Calculate your monthly interest payment. Multiply the dollar amount of your daily interest by the number of days since your last payment.
$1.90 x 30 = $57
How is Student Loan Interest Applied?
As you continue to make payments on your student loan, your principal and the amount of accrued interest will decrease. Lower interest charges means that a larger portion of your payments will be applied to your principal. Paying down the principal on a loan is known as amortization.
How Accrued Interest Impacts Your Student Loan Payments
The smart money approach is avoiding capitalized interest building up on your loan while you are in school. This is because choosing not to pay interest while in school means you will owe a lot more when you come out. The more you borrow, the longer you are in school, and the higher your interest rates are, the more profound the impact of capitalization will be.
How to Find the Best Student Loan
When looking for the best student loan, you naturally want the lowest interest rate available. With a lower interest rate, the same monthly payment pays down more of your loan principal and you will be out of debt more quickly. Learn more about private student loan options with ELFI.
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