Understanding how interest works on loans, particularly student loans, is essential for managing your post-college finances. When you take out a student loan, the lender charges interest on the amount you borrow. It is usually expressed as an annual percentage rate. And it is essentially the cost you pay to borrow the money to finance your education.
The type of loan determines how the interest works and grows. And the higher the interest rate, the more you’ll ultimately pay back over the life of the loan.
Understanding how student loan interest works can help you make informed decisions about the total cost of your education. So, you can develop a repayment strategy that aligns with your financial goals.
How Student Loan Interest is Calculated
The interest on your student loan is calculated based on the principal balance, which is the total amount you borrowed. The interest rate is applied to this balance, and the resulting interest charge is added to your loan. This process continues throughout the life of the loan, with interest accruing until the loan is fully repaid.
Interest on student loans, Parent PLUS loans, and most private student loans accrues daily. To calculate the interest accrued, lenders use the following formula:
Interest = Loan Balance x (Annual Interest Rate / Number of Days in Year) x Days in Accrual Period (Such as one month since your last payment)
Compounding Interest
Compounding interest is when the interest accrued on a loan is added to calculate future interest owed. This means that interest is calculated on both the initial principal and the interest from previous periods. As a result, the loan grows at an accelerating rate. Compound interest is charged based on the overall loan balance, including both principal and accrued but unpaid interest.
So, compound interest involves charging interest on interest. If the interest isn’t paid as it accrues, it is capitalized and added to the loan balance.
For example, if the loan balance starts at $10,000 and the interest due after one year is capitalized, the new loan balance becomes $10,500 ($10,000 + $500). The interest accrued in year two is $525 ($10,500 x 5%).
Fixed vs. Variable Interest Rates
The two main categories are fixed interest rates and variable interest rates.
Fixed Interest Rates
Fixed interest rates are set when the loan is originated and remain the same throughout its life. This means the interest rate you start with is the rate you’ll pay until the loan is fully repaid. They stabilize your monthly payments but may be higher than variable rates at the time of loan origination.
Variable Interest Rates
These rates can change over time, often in response to economic or specific financial index changes. The advantage of a variable interest rate is that it may start lower than a fixed rate, potentially saving you money in the short term.
However, the downside is that your monthly payments can increase if the interest rate rises. So, it can be more difficult to budget and plan for the future. Variable interest rates can also make it challenging to predict the total cost of your loan over the long term.
Private Student Loan Interest
Private student loans typically come with higher interest rates compared to federal loans. They may also require you to make payments immediately after the loan is disbursed, although some lenders offer grace periods or deferment options. Refinancing is often the primary option for managing these loans, but it comes with its own set of challenges and considerations.
Federal Student Loan Interest
Federal student loans usually have lower interest rates and offer various repayment plans. These plans can significantly affect how much interest you pay over time. Federal loans may also be forgivable under certain conditions, and they come in two main types: Subsidized and unsubsidized loans. These two loans have differences in qualifications, but the primary interest rate difference is in how and when they begin accruing interest.
Subsidized Loans: The government pays the interest while you are in school and during grace periods.
Unsubsidized Loans: You are responsible for all the interest that accrues when the loan is disbursed.
Understanding Loan Terms and Conditions
Principal Amount
The principal amount of your loan is the original amount borrowed before any interest accrues.
Grace Period
A grace period (typically six months after graduation for federal loans) during which you are not yet required to make payments on your loan.
Capitalization of Interest
Capitalization occurs when unpaid interest is added to the principal balance, increasing the total loan amount.
Interest Accrual During Deferment and Forbearance
Interest generally continues to accrue during deferment and forbearance, which can increase the total cost of the loan, except for federally subsidized student loans.
Income-Driven Repayment Plans and Negative Amortization
Income-driven repayment plans can lower your monthly payments by basing the monthly payment on your income. However, these plans can lead to negative amortization, where your payments are less than the interest accruing, causing your loan balance to increase over time. Forgiveness under these plans is possible but not guaranteed.
The Income-Based Repayment plan (IBR), the Income-Contingent repayment plan (ICR), the Pay-As-You-Earn repayment plan (PAYE), and the Saving on a Valuable Education (SAVE) all allow this situation to occur.
How to Find Your Interest Rate
You will find your interest rate with your lender, whether that is the federal government or a private institution.
Federal Student Loans: By logging into your account, you can find the latest federal interest rates for student loans on the Federal Student Aid website and your interest rate on any federal loans you’ve taken on.
Private Student Loans: Private student loan interest rates depend on each institution and your creditworthiness. Below are interest rates from private lenders.
Impact of Interest Rates on Monthly Payments and Total Loan Costs
The interest rate on your loan has a significant impact on the monthly payment. You can see in the example below from our Loan Comparison Calculator that for a loan of $10,000 and a 10-year term, just one percentage point difference (5% vs. 6%) means $5 per month more in monthly payments and nearly $600 more in total cost. Even a seemingly small difference in interest rate can significantly impact the total amount you’ll pay back over the life of the loan.
Monthly Payment | Total Payment | Total Interest | Difference | |
Loan #1 – 5% APR | $106.07 | $12,727.70 | $2,727.70 | |
Loan #2 – 6% APR | $111.02 | $13,322.48 | $3,322.48 | +$594.78 |
Amortization Schedule
An amortization schedule shows how your loan balance decreases with each payment. It details how much of each payment goes toward interest and how much goes toward reducing the principal over the life of your loan. In most situations (unless you’re in a negative amortization case), the interest paid on each payment decreases, and the amount paid to the principal increases.
Tax Implications of Student Loan Interest
You may be eligible for a student loan interest deduction on your taxes, but this is subject to income limits and other criteria.
Student Loan Interest Deduction
Payments on student loan interest are generally tax deductible for federal income tax purposes. However, there are some eligibility requirements and limits.
Most student loan interest payers can take a deduction of up to $2,500 per year on their income tax return. It’s worth noting that the student loan interest deduction does phase out depending on your Adjusted Gross Income when you’re filing taxes.
If your filing status is single and you earn more than $75,000 in Adjusted Gross Income, the student loan interest tax deduction is reduced. If you earn more than $90,000, you can no longer claim a student loan interest deduction.
Similarly, if you’re filing jointly, the phase-out begins at $155,000, and if you earn more than $185,000 in joint Adjusted Gross Income, you’re not eligible to claim this deduction.
Strategies to Manage Student Loan Interest
While student loan interest is an unavoidable part of borrowing for your education, there are several strategies you can use to minimize the impact of interest on your overall loan repayment.
Make Interest-Only Payments During School
If possible, make payments on the interest that accrues during your in-school and grace periods. This can prevent the interest from capitalizing and adding to your principal balance, significantly reducing the total amount you’ll repay over the life of the loan.
Improve Your Credit Score
A better credit score can qualify you for lower interest rates, especially with private loans.
Lenders use your credit score to assess the risk of lending to you. A higher credit score indicates that you are at lower risk, which can result in lower interest rates on loans. Even a slight reduction in the interest rate can lead to significant savings over the life of the loan, as we have seen in previous examples.
Use Autopay Discounts
Some lenders offer interest rate reductions if you set up automatic payments. A standard rate discount is 0.25% off of your annual interest rate. This means that each month, your payment is automatically deducted from your bank account.
If you are confident you will have the funds to cover the monthly payment, this could also help you avoid late payments and any fees associated with them.
Pay More Than the Minimum Payment
Making extra payments on your student loans, even small amounts, can significantly reduce the total interest paid. By paying more than the minimum required, you’ll be able to pay off the loan faster and reduce the amount of interest that accrues over time.
In our example of a 10-year, $10,000 loan at a 5% interest rate, paying just an extra $10 per month means you’ll pay off your loan 13 months early – saving over $300 in interest payments.
Alternatively, paying off your loan in full before the term is complete will save you interest payments as well. For example, paying off your (example)$10,000 loan above just two years before the 10-year term is up can save you up to $575 in interest payments.
If you have several federal student loans from various college years, each may have a different interest rate. If you make extra payments, you can lower your total cost even more by focusing those extra payments on higher interest rate loans.
Opt for a Shorter Repayment Term
Choosing a shorter repayment plan can help you pay off your loans faster and reduce the total interest paid. While your monthly payments may be higher, the overall savings in interest can be substantial. The standard repayment term is 10 years for Federal Direct Loans, but borrowers may be eligible to choose repayment terms as long as 30 years.
The repayment periods for private loans vary and are set at the time the promissory note is signed. The example from ourLoan Comparison Calculatorbelow shows that spreading the same $10,000 loan over 15 years may have a lower monthly payment. However, the total amount paid on the loan is about $4,234, or 42% of the original loan amount, compared to a standard 10-year repayment term.
Monthly Payment | Total Payment | Total Interest | Difference | |
Loan #1 – 10-year repayment term | $106.07 | $12,727.70 | $2,727.70 | |
Loan #2 – 15-year repayment term | $79.08 | $14,234.23 | $4,234.23 | +$1,506.53 |
Refinancing and Consolidation
Refinancing or consolidating your student loans can effectively lower your interest rate and reduce the total interest paid over the life of the loan. This strategy works best if your financial situation has improved since taking out your original loans. See how refinancing can impact your monthly payments with our Student Loan Refinancing Calculator. Refinancing can lower your interest rate but may make you ineligible for certain federal loan programs.
Loan Forgiveness Programs
While loan forgiveness programs can be helpful, they should not be relied upon as the primary strategy for managing student loan debt. There are hurdles for qualification, and loan forgiveness should be treated as a last resort.
Federal student loans in the direct student loan program are generally eligible for the Public service loan forgiveness (PSLF) program. Direct PLUS loans are usually also eligible. PSLF forgives or reduces debt on student loans after the student loan borrower has made at least 120 payments if the borrower works in a qualified public service job.
Common Myths and Misconceptions
You hear a lot about student loans from high school counselors, universities and colleges, and the media. But only some things you hear are accurate, so please do your own research. In the meantime, here are a couple of common misconceptions about student loans.
“All Student Loans Have the Same Interest Rate”
Interest rates can vary based on several factors, including:
- The type of loan: fixed rate or variable
- The term of the loan: 10-year to 30-year
- The lender: government or private institution
- Your credit history: how low risk are you as a borrower of money
- The market conditions at the time the loan is made
“Interest Stops Accruing When You Graduate”
Like any loan, interest continues to accrue and compound on your remaining balance (not just the principal) until the loan is entirely paid off unless you have subsidized federal loans, which only accrue interest after graduation or the grace period.
Understanding how student loan interest works can help you make more informed decisions about borrowing, repayment, and managing your loans. Use online calculators to see how different interest rates and repayment plans will affect your monthly payments and total loan cost. If you’re proactive and informed, you can effectively manage your student loan debt and minimize the financial impact on your future.
