How Does Student Loan Interest Work?

Molly Carapiet, VP of Eagle Lending Product and Operations, First Republic Bank
March 9, 2020
How Does Student Loan Interest Work?

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 the two main types of student loans.

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 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 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 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 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 — for which some federal student loan borrowers may qualify.

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 refinance graduate student loans, may offer highly competitive rates.  Learn more about how to select a student loan refinance company.

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 have a steady income and maybe a higher credit score. If you have private student loans, now might be a good time to consider a refinance.

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. 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 student loan refinance if it will lower your overall interest rate and if you don’t plan to use special features such as forbearance or income-based repayment plans. Although these loans are not student loans, some programs, like the one offered through First Republic, offer rates as low as 1.95% APR1 with discounts. You can also get a custom rate quote in under a minute.

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.

Refinance your student loans – fixed rates as low as 1.95% APR with discounts.

1. Annual Percentage Rate. Rates effective as of March 9, 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 equal to the greater of 10% of the approved loan amount or $5,000 into the Account; and (3) an additional 0.25% for depositing and maintaining a deposit balance equal to the greater of 20% of the approved loan amount or $10,000 into the Account.

The terms of this loan may differ from terms of your current loan(s). For example, this loan does not contain special features such as forbearance periods or income-based repayment plans available for some student loans. If the debt you are refinancing was all incurred for qualified higher education expenses or to refinance a qualified education loan under the Internal Revenue Code, the interest you pay on this loan may benefit from certain deductions thereunder, and it may also be the case that this loan will not be dischargeable in bankruptcy. Applicants should contact their legal, tax and financial advisors for advice on deciding whether this is the right product for them.

Product is not available in all markets. For a complete list of locations, visit Applicants must meet a First Republic banker in person to complete paperwork. This can be done at any First Republic Preferred Banking Office. This is not a commitment to lend, all loans are subject to First Republic’s underwriting standards. Applicants should discuss loan 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. This information is governed by our Terms and Conditions of Use.