How Student Loan Interest Works

Not understanding what student loan interest is, how it accrues, and how to pay it off can cost you thousands of dollars on top of the original money you borrowed. Don’t let that intimidate you. Taking the time to grasp what interest means is an essential part of making wise financial decisions that will benefit you for years to come.

To help you best understand and manage your student loan, we’ve answered some of the most common questions about interest.

The Basics of Interest Rates

Every type of loan or credit, from student loans to mortgages to credit cards, includes an interest payment. Interest is the fee a bank or lender charges you to use their money, and the rates can vary by lender or type of loan. Lenders calculate it as a percentage of the original amount (called the principal) you borrow. For a loan to be paid in full, you must repay all of the principal and the interest.

Types of interest

There are two types of interest rates — fixed and variable.

Fixed interest rates remain the same for the duration of the loan, regardless of market changes.
Variable interest rates fluctuate throughout the loan’s duration based on changes to market interest rates.

Whether a loan has a variable or fixed interest rate largely depends on the lending institution.

Fixed vs. Variable Interest Rates

Type of Interest Rate

Pros

Cons

Fixed

Your minimum loan payment remains the same during your repayment period.
If market interest rates increase, your interest rate will not.

If market interest rates decrease, your interest rate will stay the same.

Variable

When market interest rates decrease, your interest rate will, too.
You save money in interest when interest rates are low.

Monthly minimum payments are variable — the amount changes when interest rates do.
When market interest rates increase, you will pay more in interest.

How to calculate student loan interest

Student loan interest is determined by a daily interest formula, which is the amount of interest your loan accrues each day. To calculate your daily interest amount, you must first calculate your interest rate factor.

To find your interest rate factor:

Express the interest rate as a decimal. For example, 5% interest rate = 0.05.
Divide that by 365.25 (the number of days a year, plus an extra 25% to account for leap years). For example, 0.05/365.25 = 0.00013689 (the interest rate factor).

To find your daily interest amount:

Multiply the interest rate factor by the loan balance. For example, $10,000 x 0.00013689 = $1.37 (daily interest amount).

You can take this daily interest amount to determine what you owe over a month or year. For the above example, that’s $41.10 and $500.05 in interest respectively.

Federal student loan interest rates

Federal student loans from the U.S. government have fixed interest rates. Congress sets these rates each year. Interest rates are the same for all borrowers and are good for the life of the loan, regardless of interest rate changes in the future. There are also federally regulated caps on how much interest the government can charge on federal student loans. Interest rates for federal student loans as of November 2023 range from 5.50% to 8.05% depending on the type of loan.

Private lenders such as banks set interest rates based on several factors, including the borrower’s credit history, the repayment term, and market trends. Because of these individual factors, private lender interest rates vary. As of November 2023, interest rates on student loans from private lenders range from about 7.44% to 11.62%. Private lenders also offer loans with fixed and variable interest rates.

Current federal student loan interest rates and caps are:

Type of Loan

Borrower

Interest Rate | Cap

Direct Subsidized and Direct Unsubsidized Loans

Undergraduate Students

5.50% | 8.25%

Direct Unsubsidized Loans

Graduate or Professional Students

7.05% | 9.5%

Direct PLUS Loan

Parents of Undergraduates, Graduate or Professional Students

8.05% | 10.5%

Note: Percentages accurate as of November 8, 2023.

Source: https://studentaid.gov/understand-aid/types/loans/interest-rates;

https://www.cbo.gov/budget-options/2018/54723

Interest accrual start date

All loans start accruing interest once they are disbursed. However, the point at which the borrower is responsible for repaying that interest varies based on the lender and loan terms.

For federal subsidized loans, the federal government pays the interest on your loan while you are enrolled in school at least half-time, are in your grace period, or in deferment. This period continues until 6 months after a student has graduated or is no longer enrolled in school, prompting the student to start paying off the loans.

All other loans, whether they are from the government or private lenders, are unsubsidized, meaning the borrower is responsible for repaying all of the interest that accrues from the time the loan is disbursed. This is an important factor when calculating interest payments on unsubsidized loans, because the total amount of your loan begins increasing as soon as you receive the loan.

Know your interest rate

Your interest rates, along with the other terms of your loan, should be clearly stated in the contract or promissory note you sign when you take out your loan. Do not sign a promissory note if interest rates are not clearly stated or you don’t understand all the loan terms. A promissory note is a legal contract that says you agree to the loan terms and will pay back the loan according to those terms.

Ways to Avoid Paying Excessive Interest

Your lender calculates a minimum monthly payment based on the repayment term, the principal balance, and interest. When you make your monthly payment, money is first applied to the interest that accumulated since your last payment, plus any fees your lender charges. Then the balance of your payment goes to your principal balance.

Because your interest is a percentage of your principal balance, as your principal balance decreases over time, so will your interest payments. However, this will only happen if you keep up with your interest payments from the start. Unpaid interest is added to your principal balance in a process known as capitalization. Your interest is then calculated based on this new, higher principal balance, which in turn makes your interest payments higher.

Here are tips to help you keep your student loan interest manageable:

Before starting school:

Choose a school with affordable tuition, to minimize the amount of loans you need to borrow.
Review your eligibility for federal, state, and individual level grants and scholarships. Take advantage of any “free money” you qualify for, as this can dramatically decrease the amount in loans you need to take out.
Borrow as much as possible in subsidized loans before turning to unsubsidized loans.
Shop around and do research to find private lenders with the lowest interest rates and most favorable loan terms. Your local credit union is a great place to start.

While you are in school:

If you have an unsubsidized loan, make the interest payment every month to avoid capitalization, and an increased principal balance.
For an unsubsidized loan, pay down the balance whenever possible. This will help lower your interest payments. These are called prepayments.
If you have a subsidized loan, make payments toward the principal balance. This will lower your interest payments once they become your responsibility.

When you’re done with school:

At least make the minimum required monthly payment to avoid increasing your principal balance.
Review the payment plans available for you for federal loans. For example, income-driven plans are very popular.
Whenever possible, pay more than your minimum monthly payment, because this extra amount will go toward decreasing your principal balance, and therefore will also decrease the amount of interest you owe.
If you have private loans, consider refinancing to get a lower interest rate.