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