Most college graduates — more than seven in 10 — rack up student loan debt, but many borrowers don’t fully understand exactly how their loans work or how their interest accumulates. However, interest payments alone can add up to big bucks. Knowing how student loan interest works can help borrowers learn effective methods to pay down their loans while reducing the overall total paid over time.
So, what are the different types of student loans? There are two primary types: federal and private. These loan types have significant differences; however, many borrowers carry both types of loans. It’s important to understand the distinctions to generate a repayment strategy for each type.
Federal Student Loans
Federal student loans are funded by the federal government and have a fixed interest rate that’s usually compounded daily. Federal student loan monthly payments generally remain the same from month to month, which means there are no surprises when it comes time to pay your monthly bill. At the same time, a fixed interest rate means that the interest rate will remain unchanged for the entire life of the loan. That means as economic conditions change — for better or for worse — the terms of your loan will remain the same.
How do federal student loan interest rates work?
Depending on your type of loan, interest may accrue while you’re in school. Luckily, it will not compound until you enter repayment. Compounding means that all of the interest that has accrued gets added to the principal balance and then you have to pay interest on the interest you have already accrued. Regardless of whether interest is compounding, every day that the loan is outstanding, interest will be calculated and added to the outstanding balance by using this formula:
Interest rate ÷ number of days in the year
The resulting number is known as your interest rate factor.
For example, assume you hold a federal student loan with an annual interest rate of 4.5 percent and it’s not a leap year. Your interest rate factor would be calculated as follows:
Interest rate ÷ number of days in the year = interest rate factor
0.045 ÷ 365 = 0.000123
Every day, the equivalent of your interest rate factor will be added to your outstanding balance like this:
Outstanding principal balance x number of days since your last balance x interest rate factor = interest added to your account
Now, assume you have an outstanding federal student loan balance of $25,000. On day one, interest would accrue as follows:
Outstanding principal balance x one day x interest rate factor = new interest
$25,000 x 1 x 0.000123 = $3.075 or $3.08
Let’s assume you are only in school for one full year. So your balance when you graduate:
Outstanding principal balance + new interest = new principal balance
$25,000 + ($3.075 x 365) = $26,122.38
The next day when you enter repayment, your interest will begin compounding daily and will accrue on the new balance each day:
Outstanding principal balance X one day X interest rate factor = new interest
$26,122.38 X 1 X 0.000123 = $3.213 or $3.21
Doing the math can show you just how important it is for a borrower to at least pay the amount of the accrued interest. Still, as the principal balance decreases, so does the amount of monthly interest owed. That means more of the monthly payment can be applied toward the principal portion of the payment. In short, a borrower who can apply extra payments toward a student loan can pay it off faster but can also significantly decrease the total amount they’ll pay in interest over the life of the loan.
On the whole, you should know that rates for graduate school loans or for funds borrowed by parents tend to be higher. Check out the Federal Student Aid Office’s website for details and interest rates of specific loan types.
When does federal student loan interest start to accumulate?
In general, it depends on the type of loan.
Subsidized loans: These loans do not accrue interest while you are in school at least half-time and then during a six-month grace period once you finish school. There are also certain conditions like an economic hardship, where a deferment of payments (and interest payments) may be allowed. Thus when you graduate, your principal balance will be only the amount of loan you took out ($25,000 in our example above) and any associated origination fees.
Unsubsidized loans: Interest will begin to accrue when the loan is disbursed, even while you are in school. Even while the interest accrues, student loan payments are not due while you’re in school. That interest can really add up over four years for unsubsidized student loan borrowers who don’t make payments while they’re in school. Interest is not compounded daily while you’re in school or on your six-month grace period, however. This means that the balance used to calculate interest will not include previously accrued interest.
Private Student Loans
Private student loans, in contrast, are funded by non-government, financial institutions — such as your community bank or credit union. Many private loans have variable interest rates that fluctuate based on current economic conditions. Unlike federal student loans, all private student loans accrue interest while you are in school and some even require payments while you are in school.
Moreover, private student loans do not offer certain special features — like income-based repayment or public service loan forgiveness — which some federal student loan borrowers may qualify for.
How does private student loan interest work?
Interest for private student loans begins to accumulate when the loan is disbursed and the rate can vary widely, based on the lending institution. Some lenders, particularly those who offer post-graduation refinancing and consolidation programs, may offer highly competitive rates. In general, private student loan rates are based on the riskiness of the borrower to repay their loans, which is why many require a parent as a co-signer on the loan to get the best rate. Thus many borrowers opt to refinance their loans after they graduate and their perceived riskiness has decreased — they may have a steady income and a higher credit score.
Student Loan Repayment Best Practices
There are certain strategies borrowers can use to decrease the amount of interest they will pay over the life of the loan, while possibly decreasing how long it will take to pay back the funds:
- At the minimum, pay the monthly interest due, so your loan balance doesn’t continue to grow while you’re still in school.
- Once your budget allows, start to pay extra with each monthly payment. Add $100 per month to a $25,000 loan with a 4.5 percent interest rate and you could shave $2,064.78 off the overall interest due over the life of the loan and pay off your loan 39 months earlier.
- Make lump sum prepayments when possible, using bonuses and tax refunds. These payments will be applied like a typical monthly payment: Interest is paid first, then the remaining is applied to the principal amount. A single $1,000 lump sum payment applied at the beginning of a 10-year term can shave $546.64 off the total interest payments of that $25,000 loan.
- Consider a student loan refinance if it will lower your overall interest rate and if you don’t plan to use government-sponsored programs. Some programs, like the one offered through First Republic Bank,1 offer rates as low as 1.95 percent APR.2
In the end, knowledge is power. The more you know about how student loan interest works, the easier it will be to find a strategy that most effectively allows you to reduce your balance as quickly as possible.