How Is Interest Calculated On Student Loans
How Do Interest Rates Work On Student Loans?
Student loans are a great way to help you pay for your education, but they can be overwhelming, especially if you’re not sure how interest rates work on student loans. We’ve got the answers.
First things first: what is a student loan? A student loan is a type of financial aid that helps you pay for college or vocational school by giving you access to funds that aren’t offered by scholarships or grants alone. The money comes from different sources, including both private companies and government organizations like the Department of Education (DOE).
How does interest work on student loans? If your loan was provided through the DOE, then the interest rate will be set based on the current federal rate set by Congress every July 1st. These rates vary depending on various factors including inflation and economic growth in general. If your loan came from another source (like a bank or other lender), then it may have its own policy regarding how much interest should be paid back each month or even year depending on how much time has passed since graduation day!
How Is Interest Calculated On Student Loans
To better understand how student loan interest works, let’s start by defining what “interest” means.
Interest on a loan of any kind – college, car, mortgage, etc. – is, essentially, what it costs to borrow money. It is calculated as a percentage of the principal (the amount you borrow), and this percentage is what’s known as your interest rate.
How does student loan interest work when paying back your loans?
Student loan interest rates can be fixed (unchanging for the life of the loan) or variable (fluctuating throughout the life of the loan). In both cases, the lower the interest rate, the less you’ll owe on top of the principal, which can make a big difference in the total amount you’ll owe on your loan over time. Federal loan interest rates remain fixed for the life of the loan. Private student loans vary by lender, but most lenders offer both variable and fixed interest rates.
A student loan is often a long-term commitment, so it’s important to review all of the terms of your promissory note (sometimes called a credit agreement) before signing. This note is just how it sounds – an agreement or promise you make to pay back your loan within the parameters laid out by your lender.
Terms in a credit agreement include:
- Amount borrowed
- Interest rate
- How interest accrues (daily vs. monthly)
- First payment due date
- Payment schedule (how many payments – or “installments” – it will take to pay back the loan in full)
Your student loan will not be considered repaid in full until you pay back both the principal and the interest. To better understand how these costs combine, let’s dive into some common questions about student loan interest.
Your interest rate is determined by your lender. In most cases, if you’re considered a riskier candidate (and many students are, simply because they lack credit histories and steady incomes), the loan can be more expensive by way of a higher interest rate. To help secure a lower interest rate, students often apply with a cosigner. It might be difficult, but it’s not impossible to get a private student loan without a cosigner.
This applies more to private student loans than federal student loans, which have a separate application process that does not always consider the credit worthiness of applicants.
How is interest calculated on federal student loans?
Federal student loans, which are issued by the government, have a fixed interest rate (unchanging for the life of the loan), which is determined at the start of the school year. The rate determination is set in law by Congress.
Federal student loans and simple daily interest
Federal student loans adhere to a simple daily interest formula, which calculates interest on the loan daily (as opposed to being compounded monthly).
Since federal student loans are issued annually (and they don’t calculate your yearly balance for you), it’s fairly simple to calculate the amount of interest you’ll owe that year. Just take your annual loan amount (the principal), multiply it by your fixed interest rate, then divide that amount by 365:
Principal x Interest Rate / 365
Example:$5000 x 5% / 365 = 0.68 (68 cents per day will accrue on this loan)
With these stabilized variables, interest on federal student loans can be easier to calculate and predict than interest on private student loans. However, since both types of loans might be required to cover costs, it’s a good idea to understand how interest works on both.
How is interest calculated on private student loans?
Private student loans, which are issued by banks, credit unions, and other non-government entities, can have either fixed or variable interest rates, which can fluctuate during the life of a loan.
Student loan interest rates can vary from lender to lender, to get a better understanding, let’s take a look at an example.
If your loan balance is $2,000 with a 5% interest rate, your daily interest is $2.80.
1. First we calculate the daily interest rate by dividing the annual student loan interest rate by the number of days in the year.
.05 / 365.25 = 0.00014, or 0.014%
2. Then we calculate the amount of interest a loan accrues per day by multiplying the remaining loan balance by the daily interest rate.
$20,000 x 0.00014 = $2.80
3. We find the monthly interest accrued by multiplying the daily interest amount by the number of days since the last payment.
$2.80 x 30 = $84
So, in the first month, you’ll owe about $84 ($2.80 x 30) in monthly interest. Until you start making payments, you’ll continue to accumulate about $84 in interest per month.
Be sure to keep in mind that as you pay off your principal loan balance, the amount of interest you’re paying each month will decrease.
direct unsubsidized loan interest rate
Interest is paid to a lender as a cost of borrowing money. Interest is calculated as a percentage of the unpaid principal amount. Unlike other forms of debt, such as credit cards and mortgages, Direct Loans are daily interest loans, which means that interest accrues (accumulates) daily. Depending on whether your loans are subsidized or unsubsidized, you may or may not be responsible for paying the interest that accrues during all periods. Learn about the differences between subsidized loans and unsubsidized loans.
If you choose not to pay the interest that accrues on your loans during certain periods when you are responsible for paying the interest (for example, during a period of deferment on an unsubsidized loan), the unpaid interest may be capitalized (that is, added to the principal amount of your loan). Learn more about capitalization.
Try This Resource
Federal Student Loan Programs—Lists federal student loan programs with loan details and award limits.
How is interest calculated?
The amount of interest that accrues (accumulates) on your loan between your monthly payments is determined by a daily interest formula. This formula consists of multiplying your outstanding principal balance by the interest rate factor and multiplying that result by the number of days since you made your last payment.
Simple daily interest formula:
Interest Amount = (Outstanding Principal Balance × Interest Rate Factor) × Number of Days Since Last Payment
What is the interest rate factor?
The interest rate factor is used to calculate the amount of interest that accrues on your loan. It is determined by dividing your loan’s interest rate by the number of days in the year.
What is capitalization and how does it relate to interest?
Capitalization is the addition of unpaid interest to the principal balance of a loan. Generally, during periods when you are making payments on your federal student loans, your monthly loan payment will cover all of the interest that accrues (accumulates) between monthly payments, and you won’t have any unpaid interest. However, unpaid interest can accrue under certain circumstances. For example, you are not required to make monthly payments during a period of deferment, but if you have an unsubsidized loan, interest continues to accrue during the deferment period, and you are responsible for paying the interest. Unpaid interest may also accrue if you are repaying your loans under an income-driven repayment plan, and your required monthly loan payment is less than the amount of interest that accrues between payments.
When the interest on your federal student loan is not paid as it accrues during periods when you are responsible for paying the interest, your lender may capitalize the unpaid interest. This increases the outstanding principal amount due on the loan. Interest is then charged on that higher principal balance, increasing the overall cost of the loan. Depending on your repayment plan, capitalization may also cause your monthly payment amount to increase.
Unpaid interest is generally capitalized
following periods of
deferment on an unsubsidized loan and/or
forbearance on any types of loans find out more about the differences between deferment and forbearance
following the grace period on an unsubsidized loan;
if you voluntarily leave the Revised Pay as You Earn, Pay as You Earn (PAYE) or Income-Based Repayment (IBR) plans (learn more about income-driven repayment);
if you fail to annually update your income for some of the income-driven plans (learn about recertifying your income); or
if you are repaying your loans under the PAYE or IBR plans and no longer qualify to make payments based on income.
For example, on a $10,000 Direct Unsubsidized Loan with a 6.8% interest rate, the amount of interest that accrues per day is $1.86 (find out how interest is calculated). If you are in a deferment for six months and you do not pay off the interest as it accrues, the loan will accrue interest totaling $340. At the end of the deferment, the accrued interest of $340 will be capitalized, and you’ll then be charged interest on the increased outstanding principal balance of $10,340. This will cause the amount of interest that accrues per day to increase to $1.93. Capitalization of the unpaid interest may also increase your monthly payment amount, depending on your repayment plan.