How Does Student Loan Interest Work?

Unfortunately borrowing money isn’t free you do have to pay it back plus  interest. Now the way interest works essentially when you’re looking at different loans have it be  a federal loan or a private student loan you’re going to see an interest rate attached there. And it’s not as simple as understanding what that interest  rate is there’s a little bit more and a little bit more digging you should do to understand  how student loan interest works. There’s two different ways that interest can be applied  it can be applied either using a simple daily interest calculation or a compounding interest calculation.

For the most part when we’re talking about student loans specifically  interest will probably be calculated using a simple daily interest formula and what does that  mean? Essentially you will only be charged interest 
on your outstanding principal balance not on your  outstanding principal balance and any outstanding 
interest you have so that’s important to keep in  mind on how a simple daily interest calculation 
is used. And just in case you encounter something  that’s talking about compound interest a compound 
interest formula will charge you interest on the  amount you borrowed your principal balance as well 
as any outstanding interest you also have. Now what  you also need to know is what type of student 
loan do you have?

Do you have a federal student  loan? Is it a subsidized federal student loan or an unsubsidized federal student loan? Because these  things do matter if you have a subsidized federal student loan like a direct stafford subsidized  loan there’s a reason why this loan is beneficial and why people want to have that type of loan  over other types of loans it’s because there is an interest subsidy while you’re enrolled  in school at least half time during your grace period and during periods of authorized deferment.

And during those periods you actually have your interest covered by the government that’s also why  it’s known as a need-based loan it is a loan that has great borrower benefits attached to it. Now if you have an unsubsidized federal loan something like a direct stafford unsubsidized student loan  or a direct plus loan and that could be either a grad plus loan or a parent plus loan, the loan does  not have a subsidy meaning interest is accruing in your responsibility to repay along with the amount  you originally borrowed on the date it’s actually disbursed to you. And for private student loans  there are no subsidies covered by the government or anybody else with a private student loan  kind of like the unsubsidized loan in the federal 
program interest will be your responsibility from  the day that loan is disbursed to you.

Even though we’re talking about how interest is only going to  be calculated based on your outstanding principal balance that doesn’t mean that your outstanding  principal balance can’t change there is something known as interest capitalization  how interest capitalization works when we’re talking about student loans there are certain  periods of time where your lender or your servicer can take any outstanding interest and capitalize  it or add it on to your outstanding principal balance meaning you’re increasing your total  outstanding principal balance that would also change how your interest is being calculated  using the simple daily interest formula it’ll be off of that higher amount than the amount  you originally borrowed. In the federal program there’s very specific times where your lender  servicer is allowed to do this when it comes to private student loans you want to double check and  read your terms and conditions to see how often your lender will be capitalizing any outstanding  interest onto the principal balance of your loan.

When it comes to the federal student loan program  some common times this happens any change in 
repayment status so going from an in-school  and grace period like an a common thing before you 
enter repayment and entering that repayment status  is actually a capitalization event which means 
your servicer will take any outstanding interest  before you start making payments on your loan 
if there’s any there and then capitalize that  and add it to your principal balance and then you’ll start making payments based  on your repayment term the repayment plan you picked and so forth so that’s why we and  many others out there who work with different financial products will recommend that you make interest payments while you’re in school so when you get to the time where interest is going to be  capitalized before you enter repayment there’s nothing to add on to that principal balance.  

so that’s just something to keep in mind and get an idea of why we always give that advice to make  payments while you’re in school at least to cover your outstanding interest same thing with private  student loans same advice there if you’re in school and you’re able to you should at least make  payments to cover the interest that’s accruing every month in order to avoid any capitalization  or any additions onto your principal balance some lenders will actually with a private student loan  give you that option up front when you take out the loan they’ll ask you for different ways you  want to repay that plan to repay that loan you can actually build it in from the beginning and choose  an interest only payment while you’re enrolled in school and meet all the other eligibility criteria  on that loan. There’s other ones that are 
offered like deferred payment which would  follow more of that federal model when your loans aren’t required to start repayment until  you drop below half-time enrollment and then you have a grace period on top of that  but keep in mind if you’re borrowing loans your freshman year and you’re planning to be there  for four years and they’re unsubsidized funds meaning interest will be your responsibility  you’ve got at least four and a half years so you got your four years in school and your six month  grace period where that loan is just getting more and more expensive because you’re going to have  interest charged every single day on there.

Now if you see something like a five percent interest  rate that doesn’t mean because we’ve got a lot 
of confusion of what that really means and how  it’s calculated. Not to get too technical it’s 
not actually five percent of your loan that’s not  what that means when it comes to applying interest 
to the amount you’ve borrowed the way the simple  daily interest formula kind of works is you take 
the amount you borrowed say fifty five hundred  dollars and multiply it by your interest rate 
of five percent and then you divide that by 365  the total days in a year.

And that will actually give you your daily cost of your loan so in  this example of a five thousand five hundred dollar loan with a five percent interest rate  your daily cost is about 75 cents. Now 75 
cents doesn’t seem like a really big number  for one day but say you’re not making payments 
on your loan and your interest is accruing at  that 75 cents for 365 days by allowing interest to 
accrue for one year you’re adding on an additional  275 dollars to your loan once again some people 
might think that’s not that crazy for a whole year  but if you’re having that loan just accrue 
interest for four and a half years that can be  about fifteen hundred dollars so you’re adding an 
additional fifteen hundred dollars to the amount  you borrowed on your loan freshman year. Now that’s 
a pretty simple example there could be other  factors that could change the way your interest 
is calculating but that’s just to get an idea  of how much a loan can cost you over time.

So, interest, it’s definitely important to go  out there and compare different interest rates and also understand how they’re applied to your  loan if you have a subsidized loan you actually get a little bit of help there you have some time  where the government will be responsible for covering the interest on your behalf but it does  not last forever. Also if you have an unsubsidized loan you want to know that the interest will be  your responsibility the whole time that’s why understanding what’s in your financial  aid offer letter is so incredibly important to understand different terms and conditions on there

2 thoughts on “How Does Student Loan Interest Work?”

Leave a Comment