Student Loan Interest: How It Works

First Republic Bank
May 12, 2021

According to 2020 data, 70% of college students in the United States now graduate with student loan debt. If you’re among the majority of graduates with student loan debt, understanding how the interest rate works can help you in choosing the best method for paying off your debt, avoiding hefty interest payments, and reducing your overall repayment total.

Note: Currently, all payments for certain types of federal student loans are suspended until September 30, 2021 per an executive order by the president. Interest will not accrue during this time period.

While interest will not accrue on federal loans during this time period, these payment suspensions do not apply to private student loans. Therefore, it is important to understand your student loan type and the repayment options that come along with them.

There are two primary types of student loans: federal and private. Many borrowers carry both federal and private student loans; hence having a clear understanding of these loan types becomes crucial in deciding the right repayment strategy.

Loan Type 1: 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 you receive 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 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

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 Department of Education's 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. There are two main types of federal student loans, and their interest rates work very differently:

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 6-month grace period, however. This means that the balance used to calculate interest will not include previously accrued interest.

Loan Type 2: 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’re in school, and some even require payments while you’re in school, as well.

Moreover, private student loans do not offer certain special features — like income-based repayment or public service loan forgiveness — for which some federal student loan borrowers may qualify.

How does private student loan interest work?

The interest rate for private student loans can vary widely and depend on the lending institution. Some lenders, particularly those who refinance graduate student loans, may offer highly competitive rates.

In general, private student loan interest rates are based on the riskiness of the borrower, which is why many require a parent as a loan co-signer to lock in the best rate. Thus, many borrowers opt to refinance their loans after they graduate and their perceived riskiness has decreased, as they may have worked toward a steady income and high credit score. If you have private student loans, now might be a good time to consider a refinance.

When does private student loan interest start to accumulate?

Interest for private student loans begins to accumulate when the loan is disbursed. While the repayment terms are dependent on the lender, the interest rate can be either fixed (interest rate remains unchanged for the entire life of the loan) or variable (interest rate can change over time).

Many private loans require repayment to begin while you’re still in school, but some lenders allow deferred repayment until you graduate. It's important to read and discuss your student loan agreement with your lender to fully understand how they charge interest on your private loan.

Student Loan Repayment Practices

There are certain strategies borrowers can use to decrease the amount of student loan interest they will pay over the life of the loan, while possibly decreasing how long it will take to pay back the funds. These include:

  • Pay the monthly interest due, at a minimum, 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 10-year term, $25,000 loan with a 4.5% 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 pre-payments 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 on top of your regular monthly 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 refinancing your student loans which may lower your overall interest rate. This is a good option if you don’t plan to use federal student loan features such as forbearance or income-based repayment. One way to refinance your student loans is with a personal line of credit, which can offer more flexibility and lower interest rates compared to other options. First Republic’s Personal Line of Credit offers borrowers fixed rates as low as 2.25% APR after discounts.¹ Please note, this is not a student loan and you may be permanently giving up the benefits of a student loan such as certain deferment, forbearance, and forgiveness options.

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.


1. Annual Percentage Rate. Rates effective as of 06/15/2020 and are subject to change.

Borrower must open a First Republic ATM Rebate Checking account (“Account”). Terms and conditions apply to the Account. If the Account is closed, the rate will increase by 5.00%. Rates shown include relationship-based pricing adjustments of: 1) 2.00% for maintaining automatic payments and direct deposit with the Account, 2) 0.50% for depositing and maintaining a deposit balance of at least 10% of the approved loan amount into the Account, and 3) an additional 0.25% for depositing and maintaining a deposit balance of at least 20% of the approved loan amount into the Account.

Personal Line of Credit consists of a two-year, interest-only, revolving draw period followed by a fully amortizing repayment period of the remainder of the term. Draws are not permitted during the repayment period. Full terms of 7, 10 and 15 years available.

This product can only be used for personal, family or household purposes. It cannot be used for the following (among other prohibitions): to refinance or pay any First Republic loans or lines of credit, to purchase securities or investment products (including margin stock), for speculative purposes, for business or commercial uses, or for the direct payment of post-secondary educational expenses. This product cannot be used to pay off credit card debt at origination.

Personal Line of Credit minimum is $60,000; maximum is the lesser of $350,000 or debt to be repaid at origination plus $100,000. Line of credit cannot be fully drawn at origination.

The terms of this product may differ from terms of your current loan(s) that are being paid off, including but not limited to student loans. By repaying such loans, you may permanently be giving up tax and repayment benefits, including forbearance, deferment and forgiveness, and you may not be able to re-obtain such benefits if this loan is refinanced with another lender in the future.

Contact your legal, tax and financial advisors for advice on deciding whether this is the right product for you. Terms and conditions apply.

Product is not available in all markets. For a complete list of locations, visit Applicants must meet a First Republic banker to open account. This is not a commitment to lend; all lending is subject to First Republic’s underwriting standards. Applicants should discuss line of credit terms, conditions and account details with their banker.

The strategies mentioned in this article may have tax and legal consequences; therefore, you should consult your own attorneys and/or tax advisors to understand the tax and legal consequences of any strategies mentioned in this document.

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