How Does Student Loan Interest Work?

How Does Student Loan Interest Work?

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.

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.

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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

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  • chrisald

    Great explanation of the loan interest process. Thank you.

  • shorething32

    My credit cards are being paid of so much faster than ANY of my Federal loans. Even my private loans are being paid off so much faster as well. The federal loans are what is killing me. The interest being taken out first is what keeps making it harder and harder to get the principal down. a $50 payment gets me about 14 dollars applied to principal. How the heck can I pay these loans off if they just keep making it more and more difficult. I understand the revenue stream for student loans in 2013 is 17 billion dollars but is that worth keeping an entire generation in debt unable to buy a home, car or even start a family? All I know is this country is not getting any better in the future than our current state. I will never be able to enjoy life anymore thanks to the Federal Student loans. Worst mistake in my life was taking on Federal Student loans thinking they were better than Private loans and I am sadly learning the hard truth about it.

    • I’m really sorry to hear this! It’s terrible that they are not allowing you to direct the extra payments toward your principal balance. Have you tried calling and asking how to make those payments go toward principal? Anyway, I wish you luck with your repayment, and don’t forget to check out our student loan resource center: And as well. Let us know if we can help further.

      • shorething32

        I am working on talking to my lenders now. I always seem to get told the wrong terminology or I get different answers from each person I speak too. Its frustrating but I am not about to stop paying on my obligation. The one thing that keeps me going is I know in about 18 months I will have my credit cards and private loans paid off which will really help me out and allow me a few extra bucks for my Federal Loans. I did however catch FedLoan over charging me for the IBR plan. My understanding is that it is capped at 10% of your income and if you make more you pay. The tried to charge me $135 more a month which is well over 10% so now I have to fight them on that. I wish there was a way to request a specific lender because I had Nelnet and I enjoyed working with them before everything was transferred to Fedloan. Nelnet never kept me on hold forever and was always pleasant to talk too and ALWAYS responded back. FedLoan is slow to respond and always gives me a run around with bad information. I just find it to be difficult that us in repayment have no voice. I will definitely check out the links and thank you for your article as it helps.

        • Hi, I’m glad you found the article helpful. And I’m sorry to hear that you’ve had trouble with FedLoan customer service. It’s unfortunate that some of these loan servicing companies are not very good about providing timely support to their customers. I’m glad you’re staying on top of the payments and making sure they are charging you the correct amount, though. Good luck and definitely let us know if we can answer any other questions!

        • The formula for IBR (for now as it will be changing for borrowers who have first loan on or after 7/1/14) is AGI-150% of the poverty line; after you have this figure multiply is by 15% and divide this answer by 12 for your payment total!
          As far as choosing a servicer, if you consolidate your loans (if you haven’t already done so) you can choose between Great Lakes, Nelnet, FedLoan and Sallie Mae; if you are doing Public Service Forgiveness you must be with FedLoan

          • Kiki

            Nelnet also offers public loan forgiveness

          • In order to qualify for PSLF you must fill out an Employment Certification Form. Once approved you will be sent to FedLoan Servicing as they are the exclusive PSLF servicer. However in the same way if you are disabled Nelnet exclusively handles the permanent disability discharge process. You can access more information about that at

    • GeneralObvious

      You don’t want private loans for your student debt. Most private loans (i.e. your credit card) will compound the interest daily. When interest is compounded it is added to your principle, meaning you are charged interest on your accrued interest. This is why your private loan payments are taken directly from the principle, they are lumped into one total sum.

      For example:
      A $1200.00 loan at 10% interest would cost $120.00 in interest at the end of the year.
      1200 x 10% = $120.00

      The same loan on your credit card (interest compounded daily) would cost approximately $136.21 in interest at the end of the year.
      1200e^(.1) = $136.21

      If you want to bring your loans down quickly pay more than the minimum every month and specify that the extra payment go specifically to the loans with the highest interest rates.

      For example:
      On a loan with a 7% interest rate, you will pay $7 in interest for every dollar you owe.

      On a loan with a 3.5% interest rate, you will pay $3.50 in interest for every dollar you owe.

      In this scenario paying off the loan the with the 7% interest rate will reduce your interest payments 100% faster than paying off the 3.5% loan first. The actual amount of the loan is irrelevant for this.

      • Chris Richardson

        Well, my interest rate, for ONE consolidated loan, $21,400 is at an Unsubsidized 6.650%.
        I pay double the requested amount.
        So you are saying 6.65% of my payments should go to interest.
        But EVERY payment from every month has 29% going to the interest, and only 61% going to principal! What is that???

        My credit cards and car loan DO NOT work like that, they apply only the interest stated, and the second half of my double-payment would go straight to principal.
        IF EVERY payment I make to NELNET has 29% ripped out for interest—well—logic states that my quoted 6.65% is a lie, and I’m actually paying a criminal amount 29% interest.
        I’m soooo confused and Nelnet won’t tell me anything helpful—just the same 3 generic answers that are on their FAQ.

        • GeneralObvious

          You are comparing apples and oranges. Your interest rate has nothing to do with payment allocation.

          Your loan was unsubsidized, this means that it was collecting interest while you were still going to school (at a rate of 6.65%). Now that you have graduated you have outstanding interest ([$21k * 0.0665] * 4 years = $5586) + your principle ($21k) + whatever interest you incur monthly(6.65%).

          It seems to me that, the 29% of your monthly payment is paying off the interest you incurred previously while still in school ($5586 estimated). It has nothing to do with your current monthly interest rate (6.65%).

          Also, you shouldn’t consolidate your loans unless they can give you a better interest rate. You should always do the math yourself first to see which is cheaper.

          • GeneralObvious

            That interest number I estimated is probably way off, because I don’t know how much you borrowed each year, how long you went to school for, etc. Your number is probably much lower, but the idea is still the same.

          • Chris Richardson

            I’ve been out of school for 4 years now paying on it. I have NO outstanding interest. I consolidated 8 months ago.

          • GeneralObvious

            It’s still the same concept. If your loan has $20,000 outstanding, then your monthly interest would be $108.33. [($20,000*.065)/12] That means that regardless of how much you pay towards the principle every month you will still have to pay $108 worth of interest.

            If 29% of your payment is going towards interest each month, that means you are paying approximately $264 towards the principle.

            Total payment – Interest payment = Principle payment

            372 – 108 (29%) = 264 (71%)

            If you were to pay less each month the amount you are paying to interest (%) would increase.

            300 – 108 (36%) = 192 (64%)

            If you would pay even more per month, then the interest percentage would drop further.

            1000 – 108 (11%) = 892 (89%)

            The percentage of your payment going to interest is completely independent of your interest rate.

        • Chris Richardson

          Thank you very much OG G.O.
          That makes total sense.
          I am content now paying the amount I provide!

          • GeneralObvious

            Glad I could help.

      • Edgar Rodriguez

        Which loan name is the best one – please help!!

        • GeneralObvious

          Subsidized loans are always better because you won’t be charged interest while you’re enrolled in school. As far as the lenders go though, I think you’ll be stuck with whichever company your particular school uses. Interest on students loans is now capped though, so it really shouldn’t make a major difference.

      • Sebastian Alovisi

        Student loan debt interest is also compounded daily. Federal loans are non-dischargeable, non-differable. This means you can NEVER discharge them via bankruptcy. In fact, you need to demonstrate massive hardship to do this, hardship like I got hit by a truck and am a paraplegic now and can demonstrate a massive decrease to my earning potential.

  • Elizabeth Shocker

    First of all, thank you very much for this amazing article that somewhat helped me understand the whole interest rate game. But I am still very naive and uncertain if i fully understand this concept. So here is my question: I will be taking out a loan of 20,000 dollars for the first year of college and my interest rate will be 3.86%.By the end of the year, how much will i have to pay or can i pay each month and how much will it be monthly

    • Hi Elizabeth, I’m glad the article was helpful! As for your question, keep in mind that many loans do not charge interest while you are still in school. However, putting that aside for a moment, if you took out a loan for $20,000 at an interest rate of 3.86%, at the end of the year you would have been charged $772 of interest. Your monthly loan payment would depend on your lender and the repayment schedule you agreed to with them.

      • Elizabeth Shocker

        Thank you very much. that was very helpful.I always had trouble with that but now I understand. thank you

        • Great! I’m so glad it was helpful. Let us know if you have any more questions.

      • GeneralObvious

        Interest will accrue on unsubsidized student loans even while still in school.

    • derder

      who was your lender? I am hoping to find that kind of low interest rate. And all the private loans I’ve looked at seem to have the interest rates accrue during school, so which lenders do not do that?

  • Quick clarification on interest during grace…for subsidized loans if your loans was taken out on or after 7/1/12 interest will begin accruing during your grace; if before won’t begin till after 6 month grace period!

    • Thanks for this clarification. Does that apply to all federal subsidized loans?

      • It depends on the date of disbursement. If its before 7/1/12 gov’t pays interest in grace; if on or after, borrower responsible.

  • Readingluv

    I have federal sub. and unsub loans; both with the same interest rate. Which one should I try to put more money towards?

    • Alfred Ward

      It depends if you are still in school or not. If you are in school than the unsub loans are charging interest now so you should be focusing on paying those off. If you are out of school then they are both charging interest so you should be paying both and/or the one with the higher balance.

  • Guest

    I currentlt have 2 student loans. I went back to school this past September. 1 loan I put in deferment is for approximately $20,000 with an interest rate of 6.8%. The seconditions loans are the ones I’m currently taking out which are unsubsidized loans totaling approximately $20,000 with an interest of 6.2% the interest is compounded after 6 months and then interest accrues on the balance. If I can make a loan payment which one is better to make a payment towards?

  • Liamua

    Left grad school with a total of $126,000 in Stafford subsidized,unsubsized, and grad plus loans – with around $800/month in interest. Went on income-based repayments. Now 5 years later, my balance has grown to $165,000. Fun!

    (Thank the good lord Obama for loan forgiveness after 20 years under income-based repayments)

    • JudgexJudy

      I am in the same boat but guess what I just found out? you have to pay taxes on “forgiven” debt – in other words, it’s not really forgiven at all! You will just end up with a new debt and it’ll be for the IRS. I started paying down my debt this year and although some days it seems like I have a long way to go, I am almost about to be under 100K (I started with 143K). I did this all in 2015. Pay it off now, trust me. Listen to Dave Ramsey and read his getting out of debt plan!

  • Michele Bailey

    My loans are in default and my payment is currently garnished from my pay. Each paycheck 15% of my pay goes to ECMC. Seventy three percent of my payment in 2014, went towards interest. I have no idea if this is correct or not and don’t know who to ask that will give me an honest answer. There are so many frustrating things about paying my student loans off, but the biggest is that I feel there is no unbiased person or agency that can give me straight, honest answers/information. It seems everyone I’ve spoken to over the years are earning commission and their goal is to get you to pay as much as possible at that moment. I have come to the conclusion that I will never pay my loans off. I just pay what they say to pay. What else can I do?

    • Alfred Ward

      search google: studentloanproject it’s made for people in your situation. Hope it helps you

  • vlee430

    Just to clarify, I should pay an additional amount of interest accrued for the month on top of my monthly payment to avoid compound interest?

  • Hope

    Thank you so much for this article! it answer my two main questions – 1) do they compound and 2) can I pay JUST the interest at the moment and does that make a difference. Thanks

  • bluegirlredstate

    I have a large federal student loan balance that I can’t seem to make any progress on. Any extra I pay goes toward the daily interest instead of the principal, since interest accrues daily. I’m thinking about refinancing at a slightly higher interest rate into a loan that works like my car payment and mortgage – any extra would go directly to the principal. Any idea if this would be a smart move?

  • Greg Rusnak

    Is it to my advantage to pay off all accrued interest once I graduate…but before it capitalizes to principal?

  • Jeremy Wojchihosky

    I have a federal student loan currently through Navient(previously ACS, originally Wells Fargo) that is technically 5 smaller disbursements. Two of them have the same original principal and interest rate. The first has a higher payment amount allotted to it than the second one, but for some reason the first loan has $700+ capitalized interest, while the one that gets less of my monthly payment allotted, only has $42 capitalized interest.
    How can it be that on two identical loans, the one I have paid more on over the life of the loan, can have a higher remaining balance than the one I have paid less on?

    It seems like something fishy is going on.
    When I was paying through ACS and Wells Fargo, it was only displayed to me as a single loan and a single payment amount, so I never got to see how the payments were divided and applied.

    Disbursements 4 and 5 are strange as well. 4 had a lower starting principal($3500) than 5($5500). They have a fixed interest rate of 6.8%. So how is it that my capitalized interest on 4 can be 1178.54, making my balance only reduced by $170 after paying it for almost 7 years. Yet loan 5 only has capitalized interest of 248.61, and a reduction of $1800. Same interest and a higher original principal, yet less balance?

  • Adam McGeehan

    When looking at the formula for calculating daily interest (interest rate x current principal balance / days of the year) this means that payments made on the principal now will reduce interest payments in the future, correct? So let’s say I pay $100 off the principal of a loan with 5% interest this month. Next month, my daily interest payments will be reduced by (.05 x $100 / 365) correct? Sorry if this question is redundant, I’m just trying to clarify how this all works.

  • Mark Allen

    I have a couple different questions – if I may. I’ve been paying on my Stafford unsubsidised loan through ACS for 9 years. It has a fixed 6.375% interest rate. How is it that I’ve paid $21,008.45 in interest, with only $9,834.34 going toward the principle? My second question: Why is the amount going toward the principle different from month to month (March 2017 – $196.57, Feb $56.46, Jan $220.18, Dec 2016 $42.32, and so on)?