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Back when you signed on the dotted line and took out your student loans, did you understand the terms?
But now that you’re wondering how much you’ll have to pay back on your loans, you’re probably wondering: How does student loan interest work?
Understanding how student loan interest works is an important step in managing your debt. To do this, let’s answer the following questions:
Maybe things were a bit hazy, but you knew you needed loans to pay for your education. Or maybe you are a parent who wanted to help your child pay for their education and a better future.
Yet whether you’ve paid for your education or helped your child, interest rates are one of the most complicated things about student loans. The way interest rates are set, the way interest accrues, and the way payments are split between your principal balance and interest charges can be hard to understand – we’ll walk you through the ins and outs of student loan interest.
How Does Student Loan Interest Work?
When granting new student loans, the borrower signs a promissory note that explains the terms of the loan. Each part of this document is important to read and understand, as it determines how much you owe and when your payments are due. This also applies to PLUS parent loans and their interest.
The most important terms to watch out for are:
- Disbursement date: The date the funds arrive and the interest begins to accrue
- Amount borrowed: The total amount borrowed in each loan
- Interest rate: How much you have to pay to borrow the funds
- How interest is accrued: Whether interest is charged daily or monthly
- How interest is capitalized: When accrued interest is capitalized (or added) to your principal balance
- Date of first payment: When to make your first loan payment
- Payment schedule: How many payments you need to make
Lenders understand that most full-time students have no income, and if they do, it’s not enough to cover payments while in school. Therefore, it is often possible to avoid making payments while you are in school.
When does interest on student loans begin?
For students who need it, the government offers subsidized direct loans. If you qualify, the government pays your interest while you are in school, so your balance does not increase. Once you’ve graduated, however, interest becomes your responsibility.
Unsubsidized loans, on the other hand, charge interest from the day the loan is disbursed. Since you are not required to make any payments, interest will accrue and you will end up with a higher loan balance than you started with.
Do Parent PLUS Loans Bear the Same Interest? Unfortunately, there are no subsidized loans for parents. In addition, regular repayment begins after full loan disbursement (unless you request a deferral).
How is interest on student loans calculated?
Your required loan payment will be the same each month. However, when you make a payment, interest is paid before the money is used to reduce your principal. The rest of your payment is applied to your main balance.
Your interest rate is divided by the number of days in the year to get your âinterest rate factorâ. The interest rate factor is then multiplied by your loan balance, then multiplied by the number of days since your last payment. The result is the amount of interest you are charged for that period.
|What about fixed and variable interest rates?|
|â Federal loans: The Ministry of Education only charges fixed interest rates, and the the rates are set annually by Congress. Fixed rates stay the same over time, unless you refinance your federal loans at a lower rate, ideally.
â Private loans: Lenders typically offer fixed or variable interest rates, and variable rates are fluid over time, making them a riskier proposition for borrowers. Some online lenders even offer hybrid rates, which offer both fixed and variable rates.
How is interest on student loans applied?
As you make payments on your student loan, your balance and the amount of interest accrued will decrease. With lower interest charges, more of your payments are applied to your principal.
During the term of your loan, the interest paid will decrease each month, which speeds up the repayment of the principal. This is how it works with amortization of student loans – a fancy way of saying “pay off the principal on a loan”.
Remember that the amount of your payment is used to pay interest and unpaid charges before you reduce your principal.
If you have an unsubsidized loan or if you are past the grant period, your loan repayment date requires you to make the same minimum payment each month. If you are on a payment plan or have deferred payments, interest continues to accrue. This amount is added to your principal, which increases your student loan balance.
If you are able, it may be a good idea to pay at least the interest each month. If you don’t, your loan balance will continue to grow and you will owe interest on any interest you haven’t paid in previous months.
In fact, if you have the capacity, making interest payments while in school can save you money in the long run.
The difference is even more pronounced when you think about the interest paid on a parent PLUS loan. Let’s say you take $ 5,000 in PLUS parent loans every year your child is in school. Here’s how interest accumulates with an interest rate of 7%:
These calculations were made using Sallie Mae’s accrued interest calculator and assumes the current federal rate on PLUS parent loans will be maintained for four years. It also assumes that you will continue to earn interest for four years on your child’s first year loan, three years on the second year loan, two years on the first year, and 12 months on the final loan.
As you can see, you’ve borrowed $ 20,000, but if you defer repayment until your child has graduated from college, your loan balance will drop to $ 23,500.
What if you don’t pay in full every month?
It’s important to remember that making partial payments will count as a missed or late payment on your credit report and may result in default.
If you’re having trouble making your payments and can’t find a way to pay them, you may want to consider a income-based repayment plan. The REPAYE program, for example, limits your payments to just 10% of your discretionary income.
Using our income-based reimbursement calculator, you can see how IBR can help you with your monthly cash flow. However, you have to be careful: interest is still a factor, and the longer you are subject to interest charges, the more you pay off in the end.
|First month payment||$ 328||$ 149||$ 179|
|Last month’s payment||$ 328||$ 0||$ 328|
|Total balance paid||$ 36,080||$ 43,591||$ 7,511|
|Total forgiveness||$ 0||$ 0||$ 0|
|Repayment period||-9.2 years||– 25 years||-15.8 years|
The above example assumes you have adjusted gross income of $ 30,000, your income grows 3.5% each year, and you have $ 30,000 in federal student debt at an average interest rate of 4 , 26%.
And what if you defer your student loan payments? Consider your PLUS parent loans. Our student loan deferral calculator can help you determine how much extra you’re paying if, for example, you have $ 20,000 in 7% debt and a 12-month deferral.
As you can see, the deferral adds $ 1,400 to the total when you are on a 10 year repayment.
While it’s possible to defer payments when you have a parent PLUS loan, the fees and interest may mean it makes more sense to avoid it if you can make room in your budget to continue paying off your loan. debt, or even consider refinancing a student loan at a lower interest rate, if possible.
How are additional student loan payments processed?
When you make your monthly payment, you have the option of paying extra. If you do, this additional payment is applied directly to the principal, which will reduce your interest in the future.
Any other additional payment made during the month is treated as a regular payment. That is, your payment is first applied to the interest accrued since your last payment, and then to your principal. Check your lender’s payment policies to make sure any additional payments will actually repay your principal.
Don’t underestimate the power of prepayments of student loans. Paying $ 50 or $ 100 more each month can save you thousands of dollars in interest, depending on the terms of your loan. Check out the student loan prepayment calculator to see how much you can save by paying a little more each month.
What does the interest on a student loan mean to me?
Delaying payments or just making the minimum each month will leave you with significant interest charges over the life of your loan.
Use your new knowledge on how to calculate student loan interest on a loan and how compound interest works to prepay your loans.
You work hard for every paycheck. Pay more today to save even more later.
AndrÃ© Pentis, Eric Rosenberg and Christy rakoczy contributed to this report.
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