HERE’S EXACTLY HOW STUDENT LOAN INTEREST WORKS
Back when you signed the dotted line and took out your student loans, how well did you understand the terms? Maybe things were a little fuzzy, but you knew you needed them to pay for college.
Student loan interest is one of the more complicated aspects of student loans. How interest rates are set, how interest accrues, how payments are divided between principal and interest charges – it all can be difficult to grasp.
But while daunting at first, understanding how student loan interest works is an important step in managing your personal finances and getting out of debt that much faster.
How does student loan interest work?
When new student loans are issued, the borrower signs a promissory note explaining the terms of the loan. Every part of this document is important to read and understand, as it determines how much you owe and when your payments are due.
The most important terms to look out for are:
- Issue date: The date your loan starts to accrue interest
- Amount borrowed: The total amount borrowed in each loan
- Interest rate: How much you have to pay to borrow the funds
- How interest accrues: Your interest get charged daily or monthly
- First payment date: When you have to make your first loan payment
- Payment schedule: How many payments you have to make
Lenders understand that most full-time students do not have an income, and if they do, it is not big enough to cover student loan payments while in school. Because of that, many student loans are subsidized by the federal government, and you do not accrue any interest while still in school. Other loans, called unsubsidized, charge interest from the day the loan is issued.
Why is this important? Knowing whether your loans are subsidized or unsubsidized tells you if you are accruing additional interest, money that you have to pay back, while still in school.
How is student loan interest calculated?
While your required payment is the same each month, the dollars you pay are not treated the same. Interest is paid first, and the remainder of your payment is applied to lower your principal.
Student loan interest is typically compounded daily, which means your interest rate is divided by the number of days in the year and you are charged daily based on the outstanding balance that day.
To understand how compound interest works, let’s look at an example Direct Loan with a $10,000 balance and a 4.29% interest rate, which is the current rate for undergraduate loans.
If this loan were compounded annually, 4.29% of the loan balance would be charged annually. In this case, the interest would be $429 once per year.
However, student loans are not compounded annually, they are compounded daily. Rather than charge 4.29% once per year, that number is divided by 365 and compounds daily, or 0.0118% per day. Assuming a $10,000 balance, that is $1.175 per day.
If you make your payment on the regular schedule once per month, your daily interest from each day is added up, and your payment is applied to that accrued interest, which is about $35 per month. The rest of your payment lowers your outstanding principal.
How is student loan interest applied?
The next month, your balance is less than the $10,000 we started with, so the daily interest is lower as well. With less interest, more of your payment is applied to your principal. Over the life of your loan, your interest paid will decline each month, which accelerates your principal payment. This is known as amortization.
Remember, interest is always paid first. If you have unsubsidized loans or are past the subsidy period, your planned loan payoff requires you make the same minimum payment each month. If you are on a payment plan or have deferred payments, interest is still accrued. This amount is added to your principal, making your student loan balances higher.
If you are able, you should always pay at least the interest each month. If you don’t, your loan balances will continue to grow and you will owe interest on the interest not paid in prior months.
Still, making partial payments will count as a missed or late payment on your credit report and may cause you to go into default – which is not a good thing. This will make your loan balance grow quickly, and your future payments will still be going to interest first, delaying your payoff date and increasing your total interest expense.
If you are struggling to make payments and can’t figure out a way to make them through budgeting, you can look into an income-driven repayment plan. The REPAYE program is also worth looking into if you are struggling to make payments, as it limits your payments to 10 percent of your discretionary income.
This loan payment calculator can quickly tell you how much of your payments are going to interest and principal each year.
How are extra student loan payments treated?
When you make your monthly payment, you are given the option to pay extra. If you do, that extra payment is applied directly to the principal, which will reduce your interest in the future.
Any other extra payments made mid-month are treated like a normal payment, where your payment is first applied to all interest accrued since the last payment, then the remaining amount is applied to the principal.
Don’t underestimate the power of early payments. Paying an extra $50 or $100 each month can save you thousands of dollars in interest depending on your loan terms. Check out the student loan prepayment calculator to see how much you can save by paying a little more every month.
When I was still making student loan payments, I lived on a budget that allowed me to make a full payment every payday. Paying double each month helped me pay down my balances quickly, and I was able to make my final payment exactly two years and six days after graduation.
Compound interest is a powerful weapon
As some believe Albert Einstein once said, “Compound interest is the eighth wonder of the world. He who understands it, earns it… he who doesn’t… pays it.”
Putting off payments or just making the minimum each month will leave you with a big interest cost over the life of your loan.
Use your new knowledge of compound interest to pay off your loans early and save that money. You work hard for each paycheck. Pay more today so you can save big later.
By Eric Rosenberg and updated on March 15, 2016 for Student Loan Hero