Interest is a fee charged by a lender for the use of borrowed money. For example, student loan borrowers are charged interest on the money received from education lenders. However, many student loan borrowers do not understand how interest works.
Simple Interest and Compound Interest
Interest is the amount of money due to a lender for providing funds. It is typically expressed as an annual percentage of the loan balance.
The interest a borrower pays may be simple or compounded.
- Simple interest is charged based on the principal balance of a loan. For example, if the balance on a student loan is $10,000 and the annual interest rate is 5%, the simple interest due after one year is $500 ($10,000 x 0.05).
- Compound interest is charged based on the overall loan balance, including both principal and accrued but unpaid interest. Thus, compound interest involves charging interest on interest. If the interest isn’t paid as it accrues, it can be capitalized, or added to the balance of the loan. 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) and the interest accrued in year two is $525 ($10,500 x 0.05).
How Interest Accrues on Student Loans and Parent Loans
Interest on student loans and parent loans is charged 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
Subsidized and Unsubsidized Loans
Subsidized Federal Direct Stafford loans do not accrue interest while the student is in school or during the six-month grace period after the student graduates or drops below half-time enrollment. (Technically, subsidized loans do accrue interest, but the interest is paid by the federal government during the in-school and grace periods, as well as other periods of authorized deferment.)
Unsubsidized Federal Direct Stafford Loans and all other student loans and parent loans begin accruing interest once the loan proceeds are disbursed.
When a student loan enters repayment, all accrued but unpaid interest is capitalized. The monthly payment due during repayment is based upon the new loan balance. (The interest on non-federal loans may be capitalized more frequently during the in-school and grace periods. Some loans capitalize interest as frequently as monthly.)
For example, if the original loan balance is $10,000, the interest rate is 5%, and no payments are required during the 45-month in-school period and the six-month grace period that follows, the amount of accrued interest when repayment begins is approximately:
$10,000 x (0.05 / 365 days) x 1,551 days = $2,125
Thus, the loan balance when repayment begins is $12,125 ($10,000 + $2,125).
Interest Accrues Even During Periods of Non-Payment
Most loans do not require payments while the student is enrolled in school on at least a half-time basis and during a grace period after enrollment ends.
However, interest starts accruing for many loans as soon as the money is disbursed.
Interest continues to accrue on a student loan even when the borrower is not making payments on the loan. If the borrower is in a deferment or forbearance, or if the borrower is late with a payment or in default, interest will continue to be charged.
If the borrower is not making payments because the loan is in deferment or forbearance, interest continues to accrue and is later capitalized when repayment resumes. For example, if interest is not paid while the student is in school, the interest is added to the loan balance when repayment begins.
The only exception is for subsidized loans, where the federal government pays the interest as it accrues during the in-school and grace periods and during periods of authorized deferment.
So long as the borrower makes the required monthly payment, which exceeds the new interest, the interest due each month will be covered and the loan balance will not continue to grow.
If a repayment plan is negative amortized, the monthly payment might be less than the new interest that accrued since the last payment. In that case, the loan balance will increase.
How Loan Payments are Applied to Principal and Interest
Monthly student loan payments include both interest and principal like all amortizing loans. The monthly payments are applied first to late fees and collection charges, second to the new interest that has accrued since the last payment, and finally to the principal balance of the loan.
As the loan balance declines with each payment, so does the amount of interest due. If monthly payments are level, or a fixed amount, the principal balance declines faster with each successive payment.
When a student loan borrower sends in a payment to their lender, the payment is applied to the principal balance only after it is applied to the interest. If a borrower sends in more than the scheduled payment each month, the excess is usually applied to the principal balance, causing the loan balance to decrease faster and faster each month. Making extra payments will cause the loan will be paid off before the scheduled repayment term ends, effectively shortening the life of the loan and the total amount of interest paid.
For example, if a borrower has a $10,000 loan balance at the beginning of repayment with an interest rate of 5% and a 10-year level repayment schedule, they would make payments of $106.07 per month and pay $2,727.70 in total interest over the life of the loan. For the first month, the payment would be applied as follows:
$41.67 to interest ($10,000 x 0.05 / 12)
$64.40 to principal ($106.07 - $41.67)
However, if the borrower sends in $188.71 the first month, a greater proportion of the payment would be applied to reduce the loan balance:
$41.67 to interest ($10,000 x 0.05 / 12)
$147.04 to principal ($188.71 - $41.67)
If the borrower continues making monthly payments of $188.71, the loan will be paid off in only five years with total interest paid of $1,322.76.
How to Reduce the Total Interest Paid on Your Student Loans
There are several ways a borrower can reduce the total interest paid on their student loans:
- Make interest payments during the in-school and grace periods
- Choose a shorter repayment term
- Make extra payments to accelerate loan repayment after graduation
- Refinance at a lower interest rate
Paying the interest as it accrues each month while still in school and during the six-month grace period will keep the loan balance from increasing. When repayment begins, there will be no unpaid interest to be capitalized, and the required monthly payment will be lower.
A shorter repayment period always results in less total interest paid over the life of the loan. 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.
There are no prepayment penalties on student loans. This allows borrowers to make extra payments on their student loans without having to pay any extra fees. Making extra payments reduces the loan balance, so that more of each payment is applied to the principal than to interest. It also pays off the loan quicker, reducing the total interest paid over the life of the loans.
Finally, the amount total interest paid may be reduced by refinancing the loan at a lower interest rate. The federal government offers loan consolidation, which does not reduce the average interest rate on a borrower’s student loans. But there are many lenders who will refinance private student loans. If the credit scores of the borrower and cosigner (if applicable) have improved, the borrower might be able to qualify for a lower interest rate on a private student loan refinance.
Refinancing federal student loans into a private student loan is not recommended, as the borrower will lose access to the superior repayment benefits on federal student loans. Before refinancing federal student loans into a private student loan, the borrower should weigh the potential need for an income-driven repayment plan or desire to seek loan forgiveness. These options aren’t available with most private student loans. The fixed interest rates on federal student loans are also lower than the fixed interest rates on most private student loans.
Minimize the Interest on Interest as Much as Possible
Most student loan borrowers don’t have the income to make interest payments while they are in school. However, once student loan repayment begins, borrowers should try to avoid missing payments or seeking a deferment or forbearance. The unpaid interest would need to be repaid, along with interest charged on the interest. Conversely, accelerating student loan repayment after graduation minimizes the total interest charged on the interest that accrued during the in–school and grace periods.