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Simple vs. Compound Interest for Student Loans

Simple or Compound Interest For Student Loans
Rebecca Safier
Rebecca SafierUpdated January 30, 2023
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When you borrow student loans, you’ll have to pay back the amount you borrow, plus interest. Interest is the fee that lenders charge to let people use their money. All federal student loans and most private student loans use a simple interest formula. However, a handful of private lenders use a compound interest formula, which can result in even higher interest charges. It’s wise to understand the difference between these two interest formulas so you can understand just how much money you’ll be paying back over the term of the loan. Read on for a closer look, including:
  • Are student loans simple or compound interest?
  • What is simple interest and how does it work?
  • What is compound interest and how does it work?
  • How can you lower your student loans?  

What Is Simple Interest?

Simple interest is a method of calculating interest charges that’s based on your principal balance only. It results in lower interest charges than a compound interest formula, which is calculated based on both your principal balance and any unpaid interest charges that have accrued. 

How Does Simple Interest Work?

Simple interest is calculated with the following formula: Simple interest = principal balance x interest rate x loan term Let’s say, for example, that you owe $25,000 with an average student loan interest rate of 5% and a 10-year term. Before using the formula, we’ll convert 5% to a decimal (0.05). Then we’ll use the formula to figure out how much interest you’ll pay over the life of your loan. Simple interest = $25,000 x 0.05 x 10 = $12,500With a simple interest formula, you’ll pay $12,500 in interest charges over 10 years, in addition to the principal. The total amount you are repaying after 10 years of payments will be the $25,000 principal plus $12,500 interest for a total of $37,500. If you want to know how much interest you’re paying on a daily basis, you can divide your interest rate by 365 days in a year and multiply that fraction by your loan balance. For example: (0.05 / 365) x $25,000 = $3.42 As you can see, you’re paying $3.42 in interest every day. If you have the means to pay your loan off ahead of schedule, you’ll save money on interest.  

What Is Compound Interest?

Compound interest is another method of calculating student loan interest that takes both the principal balance and unpaid interest charges into account. Interest accrues on both the principal and the interest it earns. With the compound method, you could end up paying interest on top of interest, resulting in higher charges. The compounding schedule can also impact your costs, whether interest compounds on a daily, quarterly, semiannual, or annual basis. 

How Does Compound Interest Work?

The compound interest formula is more complicated than the simple interest formula:Compound interest = (principal (1 + interest rate) ^ number of compounding periods for a year) – principal Fortunately, you don’t have to use a pen and paper to calculate compound interest, but can instead rely on online compounding interest calculators to do the math for you. What’s easier to calculate, however, is the addition of daily interest to your charges. Take a look at how your balance and daily interest can increase if you don’t pay off the interest that accrues each day, again using the example of a $25,000 with a 5% interest rate. Day 1: (0.05 / 365) x $25,000 = $3.42 daily interest charge Day 2: (0.05 / 365) x $25,003.42 = $3.43 daily interest charge Day 3: (0.05 / 365) x $25,006.85 = $3.43 daily interest charge As you can see, your balance can keep increasing over time (and your daily interest charges along with it) unless you pay off the accrued interest as you go. Now, let’s say this interest compounded daily for 10 years at the same 5% rate noted above on the sum of $25,000. The total interest due would be $16,216.62, for a total of $41,216.62 due at maturity.

Are Student Loans Compound or Simple Interest?

All federal student loans use a simple interest formula. These include Direct subsidized loans, Direct unsubsidized loans, and Direct PLUS loans. Most private student loans also use simple interest, but a handful of private lenders may use compound interest. It’s worth reviewing your loan agreement to see which type of interest calculation your lender uses. If it opts for compound interest, consider making interest-only payments while you’re in school to prevent your balance from ballooning as interest accrues on top of interest. Note: Interest rate and annual percentage rate (APR) are not the same thing. APR is a more inclusive measure than interest rate, since it takes both interest and fees into account. When it comes to APR vs. interest rate for student loans, APR can give you a fuller sense of your costs of borrowing and help you compare loan offers on an apples-to-apples basis. 

Do Federal Student Loans Have Compound Interest?

Although federal student loans use a simple interest formula, there are situations where you may end up paying interest on top of interest. Specifically, the government might add unpaid interest charges to your student loan balance during certain events in what’s known as capitalization. Student loan interest can capitalize when: 
  • Your grace period ends 
  • You finish a period of deferment or forbearance (not counting the Covid-19 emergency forbearance; this pause on payments has been extended to June 30, 2023, and repayments could begin 60 days later) 
  • You leave or forget to recertify an income-driven repayment plan
  • You’re on income-contingent repayment (interest capitalizes annually on this plan) 
  • You consolidate your loans with a Direct consolidation loan. 
Let’s say, for example, that you borrowed $25,000 for college and didn’t make any payments during your four years in school. At a 5% rate, about $2,635 in interest would accrue while you’re in school. When your grace period ends and you start paying off your student loans, the interest will capitalize, increasing your balance from $25,000 to $27,635. At that point, interest will start accruing on your new, higher balance, resulting in higher daily charges and a larger cost overall. 

How Often Is Student Loan Interest Compounded?

Student loan interest typically accrues on a daily basis. As mentioned, you can calculate your daily interest charges by dividing your interest rate by 365 and multiplying it by your total balance. If a lender uses a compound interest formula, it will choose how often the interest is compounded. Some might compound interest on a daily, quarterly, semiannual, or annual basis. 

Comparing Compound Interest to Simple Interest

Simple interest is preferable to compound interest on a loan because it will result in lower interest charges overall. Returning to that example of a $25,000 loan with a 5% interest rate, you’d pay $12,500 in total interest charges over 10 years using a simple interest formula. If your lender uses compound interest, your interest charges would be higher; $16,216.62. Fortunately, compound interest on student loans is rare, though, as mentioned above, capitalization can sometimes occur. Recommended: Consolidating Student Loans: What You Need to Know

Lowering Your Student Loan Payments

Interest charges can make student loans expensive, especially if you’re stuck with a high interest rate. One way to reduce interest charges is to pay the interest while you’re in school. With the exception of Direct subsidized loans, interest will accrue from the date your loans are disbursed. Plus, it’s added on to your balance when your grace period ends and you enter active repayment. If you can pay off the interest as it accrues, you can prevent your balance from growing larger while you’re in school. It’s also worth signing up for automatic payments, since most lenders offer a 0.25% rate discount for using autopay. If you can afford to make extra payments, you’ll get out of debt faster and save on interest. Finally, good-credit borrowers might explore refinancing their student loans for better rates. You might qualify for a better rate than you have now and can choose new loan terms, too. At the same time, be cautious about refinancing federal student loans with a private lender, as doing so means sacrificing federal repayment plans and other protections.  

The Takeaway

Understanding how interest accrues on student loans can prevent you from getting a nasty surprise when your student loan bills are due. Although most student loans use a simple interest formula, you could end up paying interest on top of interest due to capitalization. If you can make interest-only payments while you’re in school, instead of postponing payments completely, you could lower your costs of borrowing. And, if you’re comfortable forfeiting federal benefits (such as loan repayment options), explore refinancing your student loans for better interest rates.Learn more about how Lantern can help you find and compare competitive student loan refinance rates. It’s a quick, convenient way to see just what kinds of options are available.Wondering what kind of student loan refinancing offers you might qualify for? Find out with a little help from Lantern.

Frequently Asked Questions

What kind of interest are student loans?
How often is student loan interest compounded?
Are any student loans compound interest?
Photo credit: iStock/kool99

About the Author

Rebecca Safier

Rebecca Safier

Rebecca Safier has nearly a decade of experience writing about personal finance. Formerly a senior writer with LendingTree and Student Loan Hero, she specializes in student loans, financial aid, and personal loans. She is certified as a student loan counselor with the National Association of Certified Credit Counselors (NACCC).
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