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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 August 9, 2023
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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% interest rate, for instance, you’d pay about $9,548 in interest 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 entered repayment.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 federal rate changing over time. After a three-year payment pause, the Covid-19 forbearance is set to end on Aug. 30, 2023. As a result, interest accrual on federal student loans will resume on Sept. 1, and payments will be due starting in October 2023.Recommended: Why Do My Student Loans Keep Rising and What Can I Do?

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% interest rate.Using an 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% 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 about $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. (Eligible borrowers may claim a student loan interest deduction on their federal income taxes.)A new rule took effect in July 2023, eliminating most instances of federal student loan interest capitalization. This means federal student loan borrowers will no longer face interest capitalization charges when they first enter repayment or leave a forbearance.Interest capitalization may occur when a federal student loan borrower exits a period of deferment on an unsubsidized loan, overcomes a partial financial hardship on the Income-Based Repayment Plan, or upon loan consolidation. These are the few instances where federal law requires interest capitalization on federal student loans.Again, most instances of federal student loan interest capitalization have been eliminated under a new rule implemented by the U.S. Department of Education. 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.

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 (IDR) 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.All IDR plans can end with a borrower’s outstanding balance being forgiven at the end of the repayment period. Forgiveness may come after 20 or 25 years under any of the IDR plans, but forgiveness may come earlier for some enrollees on the Saving on a Valuable Education (SAVE) Plan. Borrowers can 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. 

The Takeaway

Besides making extra payments on your student loans, you could cut down interest charges by refinancing your loans with a new lender. Student loan refinancing replaces your existing student debt with a new loan agreement. Refinancing student loans may lower your interest rate. (Refinancing for a longer term may increase your total interest costs.)One of the big disadvantages of refinancing student loans with a private lender is you’ll be forfeiting federal benefits. Refinancing federal student loans will remove your access to federal IDR plans and forgiveness programs. Refinancing may not be right for you if you’re eligible for Public Service Loan Forgiveness or Teacher Loan Forgiveness. If you’re interested in student loan refinancing, Lantern by SoFi can help. Just fill out a form and compare your refinance student loan options.Lantern can help you compare student loan refinance rates and find the best one for you.

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?
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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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