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Student Loan Interest: What It Is and How It Works

Student Loan Interest: What It Is and How It Works
Rebecca Safier
Rebecca SafierUpdated July 18, 2022
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Editor’s note: Lantern by SoFi seeks to provide content that is objective, independent and accurate. Writers are separate from our business operation and do not receive direct compensation from advertisers or partners. Read more about our Editorial Guidelines and How We Make Money.
When you take out student loans, you have to pay interest on top of the amount you borrow. Interest is basically the cost of borrowing money, and it can cost a hefty amount on top of your original loan. Fortunately, there are ways to reduce your interest charges, including making in-school payments, shortening your repayment term, or refinancing for lower rates. Let’s take a closer look at how interest on student loans works so you can prepare for this cost.

How Does Student Loan Interest Work?

Student loan interest typically accrues on student loans daily. Due to interest charges, you’ll end up paying back more than you initially borrowed. If you took out a $35,000 loan at a 5.0% interest rate, for instance, you’d pay a total of $9,548 over 10 years. The amount of interest you’ll have to pay can vary depending on the type of student loan you have and the interest rate at the time of borrowing. Subsidized student loans from the federal government, for example, don’t accrue interest until you’ve graduated. Unsubsidized federal loans and private student loans, however, start accruing interest from the date of disbursement. If you have any private student loans, you may also have been given the option of a fixed or variable interest rate. Fixed rates stay the same over the life of your loan, while variable rates can fluctuate due to market conditions. If your variable rate increases, you’ll see your interest costs (and likely your monthly payment) go up, as well. Note that federal student loans all come with a fixed rate, so you don’t have to worry about your student loan interest charges changing over time. What’s more, interest has been paused on federal student loans since March of 2020 in response to the coronavirus pandemic. 

How Does Interest Work on Student Loans When Paying Them Back?

Most student loans don’t require repayment until six months after you’ve graduated school or dropped below half-time enrollment. But unless you have subsidized loans, interest has been accruing on your balance that entire time. Once you start making payments on your loans, your payments will be applied both to interest charges and your loan amount, also known as your principal balance. Let’s go back to that example of a $35,000 loan at a 5.0% interest rate. Using Student Debt Relief’s amortization schedule calculator, we can see that you’ll make monthly payments of $371.23 on a 10-year repayment plan. The first month, $145.83 of your payment will go to covering interest charges, and $225.40 will go toward your principal balance. In the beginning, a large chunk of your monthly payments will go toward paying down the interest. Over time, however, the ratio will flip, and more of your payment will go toward paying down your balance. In your last few months of repayment, for instance, only $10 or less is going toward interest charges. The majority of the payment is applied to the principal. This repayment schedule is known as amortization. If you want to speed up your repayment timeline, consider making extra payments on your loan or interest-only payments while you’re still in school. 

How Is Student Loan Interest Calculated?

Federal student loans — and some private student loans — calculate interest with a simple daily interest formula. To calculate student loan interest on your own loans, you can start by dividing your interest rate by the number of days in a year, 365. Let’s go back to that example of a $35,000 student loan with a 5.0% interest rate. If you divide 5% (or 0.05) by 365, you get 0.000137. That’s your daily interest rate. You can then multiply that rate by $35,000 to see how much interest accrues on your loan every day. In this case, your loan is accruing $4.80 in interest charges every day. Finally, you can multiply that daily interest charge by 30 to see that your monthly interest charges are about $144. Note that some private lenders use a compound interest formula instead of a simple one, which can increase your interest charges. With a compound interest formula, your daily interest charges are added on to your principal balance every day. As a result, you end up paying interest on top of interest, leading to higher costs of borrowing over time. If you’re not sure which formula your private loan uses, you should be able to find out in your promissory note, or the contract you signed to take out the loan. 

What Is Student Loan Interest Capitalization? 

In some cases, interest can be capitalized, or added on, to your principal balance. You want to avoid capitalization events whenever possible, since they can make your loan more expensive. Here are some situations when interest is typically capitalized on your student loans: 
  • A period of deferment or forbearance comes to an end 
  • Your grace period comes to an end 
  • You voluntarily leave an income-driven repayment plan 
  • You fail to recertify your income for an income-driven repayment plan 
  • You lose eligibility for the Income-Based Repayment or Pay As You Earn plans 
Returning to our example of a $35,000 loan at a 5.0% rate, you can expect $3,689 in interest charges to accrue during the four years you’re in school. When your grace period ends, that interest could be added on to your principal, so you now owe a total of $38,689. If you want to cut down on the effects of interest capitalization, you could consider paying interest charges while you’re in school or during periods of deferment or forbearance

President Biden's Changes to Interest Payments

In August 2022, President Joe Biden announced sweeping changes to federal student loan repayment policies. Among them is a change in interest on the loans.Biden said the government will "cover the borrower’s unpaid monthly interest.... No borrower’s loan balance will grow as long as they make their monthly payments—even when that monthly payment is $0 because their income is low."More information is to be released on when this policy goes into effect.

What Happens if You Don’t Make Full Payments Each Month?

Making partial or late payments on your student loans can cause them to become delinquent or even go into default. Plus, your loans might become even more expensive if you’re not paying enough to keep up with interest charges. However, federal student loans allow you to reduce your monthly payments by applying for an income-driven repayment plan, such as IBR (Income Based Repayment) or Pay As You Earn (PAYE). These plans lower your monthly payments to 10% to 20% of your discretionary income and extend your repayment terms to 20 or 25 years. While income-driven plans can offer relief from month to month, they also can cost you more in interest charges over time. For one thing, your loans will have more time to accrue interest if you’re in debt for 20 years or more. And for another, your low monthly payment could lead to negative amortization, or a repayment schedule in which your monthly payment isn’t enough to cover your monthly interest charges. In this situation, your loan balance could actually increase, rather than decrease over time, even as you’re making monthly payments. Income-driven repayment plans can end in loan forgiveness if you make on-time payments for two decades or more. But you’ll have to weigh whether the promise of eventual loan forgiveness is worth the increased interest charges and potential negative amortization. Also, look into programs like employer student loan repayment.

How Are Extra Student Loan Payments Treated?

If you can afford to make extra payments on your student loans, you can speed up your repayment timeline and save money on interest charges. Making extra payments could be especially worthwhile if you have a loan that accrues compound interest. When you send an extra payment, lenders will typically apply it to your principal balance (assuming you’ve already paid off the interest charges for that month). But some lenders may save it for a future payment, which wouldn’t help you get ahead. Before sending your extra payment, it’s worth reaching out to your lender to ensure it will apply the payment to your principal balance. For extra motivation, use a student loan calculator to estimate how much time and money making extra payments could save you. Besides making extra payments on an occasional or monthly basis, you could also consider making payments every two weeks instead of once per month. On a biweekly schedule, you’ll end up making 13 payments every year instead of the usual 12. This approach offers an easy way to make a full extra payment on your student loans without much extra effort on your part. 

The Takeaway

Besides making extra payments on your student loans, you could cut down interest charges by refinancing your loans with a new lender. Depending on your credit and income, you could qualify for better rates than you have now. Lowering your interest rate even a small amount can have a major impact on your long-term costs of borrowing. It will also impact student loan interest deductions.At the same time, it’s important to be cautious about refinancing federal student loans. When you refinance federal loans with a private lender, you lose eligibility for federal repayment plans and forgiveness programs. Make sure to weigh the benefits of refinancing student loans with the potential downsides. If you decide the pros outweigh the cons, Lantern can help you find and compare student loan refinance options.

Frequently Asked Questions

How is interest charged on a student loan?
Does student loan interest accrue daily or monthly?
Do student loans have interest you have to pay back?
How can I avoid paying interest on student loans?
Photo credit: iStock/MicroStockHub

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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