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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 understanding interest intimidate or confuse you. Taking the time to fully 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.

What Is Interest?

Interest is the fee that a bank or lender charges you for the use of their money. It is usually calculated as a percentage of the original amount (called the “principal”) that you borrowed. In order for a loan to be considered paid in full, all of the principal and all of the interest must be paid.

Just about every type of loan or credit, from student loans to mortgages to credit cards, includes an interest payment. Interest rates vary based on a number of factors, including:

  • Type of loan
  • Lender
  • Borrower’s personal financial and credit history
  • Repayment term
  • Current market trends

Lenders charge interest for a variety of reasons, mostly related to mitigating the risk of lending money to people who may or may not pay it back.

What Is an Interest Rate?

The interest rate is the percentage of the principal that the institution charges you. 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.

There are pros and cons for both.

Fixed interest rates

Pros Cons
  • Your minimum loan payment will  not change during your repayment period.
  • Even if market interest rates increase, your interest rate will not.
  • If market interest rates decrease, your interest rate will stay the same.

Variable interest rates

Pros Cons
  • When market interest rates decrease, your personal interest rate will too.
  • You save money in interest when interest rates are low.
  • Monthly minimum payments are more unpredictable, because they will change based on interest rates.
  • When market interest rates increase, you will pay more in interest.

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

Federal student loans from the U.S. government have fixed interest rates. These rates are set each year by Congress. 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 your federal student loans.

Current federal student loan interest rates and caps are:

Type of Loan Borrower Interest Rate | Cap
Direct Subsidized and Direct Unsubsidized Loans Undergraduate Students 4.53% | 8.25%
Direct Unsubsidized Loans Graduate or Professional Students 6.08% | 9.5%
Direct PLUS Loan Parents of Undergraduates,, Graduate or Professional Students 7.08% | 10.5%

Note: Percentages accurate as of April 30, 2021

Source: https://studentaid.ed.gov/sa/types/loans/interest-rates#interest-rate-factor; https://www.cbo.gov/budget-options/2018/54723

Private lenders such as banks set their interest rates based on a number of factors, including the borrower’s credit history, the repayment term, and market trends. Because of the individual factors, private lender interest rates vary. As of October 2019, interest rates on student loans from private lenders range from about 3 percent to 13 percent. Private lenders also offer loans with fixed and variable interest rates.

How Is Student Loan Interest Calculated?

So you know what your interest rate is, but what exactly does that look like in practice? To understand how your interest accrues and how it affects your principal balance, you need to do a little math.

First, figure out the interest rate factor, which is how the overall interest translates into a daily rate. To do this, express the interest rate as a decimal:

5% interest rate = .05

Then, divide that by 365.25 (the number of days in a year, plus an extra 25% to account for leap years).

.05/365.25 = .00013689

Based on these calculations, the interest rate factor is .00013689. Multiply this number by your loan balance, for this example we’ll say that is $10,000.

10,000 x .00013689 = 1.37

This final number, $1.37, is how much interest your loan will accrue daily. Over the course of a 30-day month, your loan will accrue $41.10 in interest. Over the course of a year, it will accrue $500.05 in interest.

How Do I Know What My Interest Rates Are?

Mae student using a laptop

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 terms of the loan. A promissory note is a legal contract that states you agree to the loan terms and will pay back the loan according to those terms.

When Does Interest Start Accruing?

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. 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.

How Do You Pay Off a Loan With 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.

Ways to Avoid Paying Excessive Interest

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.
  • 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.
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.
  • 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.
  • 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.

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