Do you know how student loan interest works? When I was a student, I sure didn’t:
Several months before graduating from college, I and a group of my classmates gathered in one of the prettiest rooms on campus. On this particular day, the room was filled with financial aid office employees poised to give lots of boring PowerPoint presentations.
Each of us were handed a shiny, new folder with a photo of a college senior in a cap and gown, holding a diploma. I remember looking at that photo and thinking, “I made it!”
Then I opened the folder and saw that the inside pocket was filled with papers listing all the loans I had taken out over the previous four years. Instead of listening to what the nice financial aid people were talking about during the hour-long presentation, I sat there and added up my total student debt amount. When I left the room that day, it felt like I had a $36,000 monkey on my back.
The amount owed was given to me in understandable, black-and-white numbers: $36,000. However, this was just the principal. Understanding the interest that was being charged and coming to grips with how much interest I would be paying over the course of the loan payoff was complicated and painful.
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I had no idea how student loan interest worked the day that I entered that financial exit interview, but I would like that to not be the case for you.
Below, I’ll help you answer the question “how does student loan interest work?” based on my own experience paying off over $40,000 of student loan principal and interest charges:
Federal Vs. Private Student Loan Interest Rates
The first thing you want to do is to divide up your student loans into two categories: federal and private. This is because these two types of loans are treated differently in a variety of ways (such as in the consolidation process, repayment options, and interest accruement.
Federal student loans are sourced through the US Department of Education and will be called Direct Subsidized Loans and Direct Unsubsidized Loans, Direct PLUS loans, or Federal Perkins Loans. Private student loans are sourced from banks, credit unions, state agencies, or your school itself.
The interest rates on federal student loans are prescribed by law and are usually no higher than 8%. There are no limits on interest rates for private student loans, which means they can vary depending on the lender and the borrower.
When Interest Begins to Accrue
Now that you have your two piles of loans (federal and private), it is important to understand when interest began or will begin to accrue on your debts. For private student loans or federally unsubsidized loans, your interest begins to accrue as soon as the loan is disbursed. This means that the private loans you took out your first semester as a freshman have been accruing interest for potentially four years (keep breathing).
However, if you have federally subsidized loans, then interest will not begin to accrue until after the six-month grace period once you graduate college. In my case, $21,800 of my total student loan debt was subsidized, and this really helped in keeping down interest charges.
How to Calculate Your Student Loan Interest
Most student loans calculate interest using the Simplified Daily Interest Formula (sometimes called the Interest Rate Factor). Interest accrues on your principal balance (which includes the disbursement check amount plus any applicable loan fees) as soon as your accruement period begins. Here is a simple formula you can use to calculate your daily interest rate:
Interest Rate X Current principal balance ÷ Number of days in the year = Daily Interest
If your loan portfolio looks like mine did and you have multiple student loans with multiple interest rates, then you need to do this equation for each loan, and then add up all of the interest.
Also, realize that because the formula is based on the number of days in a year, in any given month your amount of interest paid may vary (some months have 28 days, some months have 31 days). If you are looking for just a snapshot of how much interest you are paying per year, then a simpler way to calculate interest is by allowing the lenders to do the work for you.
At the end of each year you should receive a tax document from each of your lenders detailing the exact amount of interest that you paid.
You Might Be Paying Compound Interest
You might think you’ve avoided paying compound interest. The Simplified Daily Interest formula makes it look as though no compound interest is involved with student loan debt. However, even though student loan debt generally does not have compound interest like credit card debt does, you could still incur compound interest in the period while you are still in school and before you begin your loan repayment.
You need to know when and how the capitalization of your interest will occur (capitalization of interest means the point at which your earned interest is added to the principal sum owed). Will it be added on daily/monthly (in other words, compounded), or will it be capitalized as a lump sum right before repayment occurs?
In order to avoid compound interest in either example, be sure to make interest payments each month even if you are not in your loan repayment period. It could make quite a difference over the years of debt repayment!
If you have other questions about how student loan interest works, post them in a comment below and we’ll do our best to answer them.
Image Credit: Patrick Bell