How Does Student Loan Interest Work
Student loan interest can be a confusing topic. You may find yourself asking, ‘How does interest accrue on student loans?’ or worrying about student loan compound interest. With so many different terms associated with student loans, it’s easy to feel overwhelmed.
Understanding how student loan interest works is vital in personal debt management, as interest rates are a complicated aspect of the student loan system.
In this post, we’ll answer some key questions, such as: ‘Does student loan interest compound?’ and, ‘How much is interest on student loans?’
Keep reading as we explore this topic in more detail.
What is Student Loan Interest?
Student loan interest is the amount of interest you pay over 12 months on a qualified student loan. This sum of cash includes required and voluntary pre-paid interest payments. Whether you took out a private or a federal student loan, you’ll be charged interest on your borrowed money.
Interest starts to accrue (grow) as soon as your student loan is disbursed. When your grace or separation period ends, or at the end of deferment or forbearance, all unpaid interest can capitalize. At this point, it is added to your loan’s Current Principal.
How Does Student Loan Interest Work?
Student loan interest rates are either:
Fixed – unchanging over the lifetime of your loan
Variable – fluctuating over the lifetime of your loan
In either case, the lower the interest rate, the less money you’ll owe on top of the principal. Federal loan rates are fixed for the lifetime of the loan. In contrast, private student loans tend to vary by lender. That said, most lenders offer fixed and variable interest rates.
How to Calculate Student Loan Interest
Your lender will determine your student loan interest rate. In many cases, if you are considered to be a risky candidate, you’ll be charged higher interest rates. To avoid these additional fees, it’s common practice for students to apply with a cosigner.
Cosignatories are more applicable to private student loans than federal loans. Federal loans use a different application process that rarely considers how credit-worthy applicants are.
How Interest is Calculated on Federal Student Loans
All federal student loans use fixed interest rates, which are determined at the beginning of the school year. This rate is set into law by congress every year. Calculating interest on a federal loan is relatively straightforward:
Take your annual loan amount (the principal), multiply it by your fixed interest rate, then divide that amount by 365:
Principal x Interest Rate / 365
Example: $5000 x 5% / 365 = 0.68 (68 cents per day will accrue on this loan)
How Interest is Calculated on Private Student Loans
Private student loan interest rates vary across different lenders. This can leave you wondering, ‘Exactly how much is my student loan interest?’ We recommend that you use this free student loan daily interest calculator to work out how much you are being charged.
When it comes to repaying federal and private student loans, there are several options available:
Repaying Federal Loans
- Standard Repayment Plans:
Your lender will provide a schedule containing a set monthly repayment amount. These plans last ten years for federal loans.
- Graduated Repayment Plans:
Payments start smaller and increase every couple of years. These plans are designed to clear your student debt over ten years.
- Extended Repayment Plans:
These plans extend payments beyond the standard ten years period and are designed to clear debts over 25 years. Extended Repayment Plans can be fixed or graduated and are offered to people with $30,00 or more in outstanding loans.
- Income-Based Repayment Plans:
These plans are based on a percentage of your earnings. Typically, you’ll pay about 10-15% of your income once personal expenses and taxes are covered. Payments are recalculated annually and adjusted in line with your earnings and the size of your family.
- Income-Contingent Repayment Plans:
These plans are similar to income-based plans. However, they are based upon 20% of your discretionary income (the amount of income remaining after expenses). These rates are adjusted annually, and the balance can be taxed – or forgiven- over time.
- Income-Sensitive Repayment Plans:
These plans are based on your total income before taxes and expenses and are calculated to pay off your debt within ten years.
Repaying Private Loans
As private loans are agreements between lending institutions and yourself, the lender’s rules for payment are supplied. This means you’ll pay a set amount every month. If you want to make changes to your payment plan, you must negotiate directly with the lender.
We hope this post has answered the question: ‘How does student loan interest work?’