Understanding How Student Loan Interest Works

Student loan interest can have a major impact on the amount of debt you ultimately repay. Interest on student loans is generally calculated on a daily basis, usually starting as soon as funds are disbursed. At certain points, that accrued but unpaid interest may capitalize, meaning it gets added to your loan's principal balance.

To effectively repay your student loans rather than getting bogged down in a prolonged cycle of interest accrual, it helps to have a sense of how student loan interest works and how it's calculated. That way, you'll know how to minimize it.

What is student loan interest?

Student loan interest is effectively the cost of borrowing money. It's an additional amount you pay a lender in exchange for being able to borrow funds.

For both federal and private student loans, interest is calculated based on a percentage of the total loan balance.

Current student loan refinance rates

How does student loan interest accrue?

The interest on a student loan is expressed as an annual rate. Generally, federal and private student loans charge simple interest, which is calculated on the original amount you borrowed.

For example, let's say you borrowed $30,000, and your loan's interest rate is 6.53% per year. If your balance remained the same, you would accrue $1,959 of interest over the first year ($30,000 x 0.0653). However, the interest for student loans is usually calculated daily based on your current balance. That means as you make regular payments that reduce your principal, the amount of interest you accrue each day also gets progressively smaller.

Each of your payments will first go toward paying down the interest you owe for that month, with the remainder going toward the principal balance. With each payment you make, the amount applied to the principal increases, while the portion that goes toward interest decreases.

Missing monthly payments on a student loan can be very costly. The unpaid interest capitalizes, meaning it's added to the principal amount of the loan. This increases the amount on which the interest is calculated, meaning you're paying interest on top of that interest.

Federal vs. private student loan interest rates

Another major factor impacting how student loan interest is calculated is whether a loan's interest rate is fixed or variable.

With a fixed interest rate, the rate remains the same for the life of the loan. But when a loan's interest rate is variable, the rate can change based on market conditions. It may go down, but it can also go up.

All federal student loans have fixed interest rates, which makes it easier to predict your loan costs well into the future. Private student loans, on the other hand, can have either fixed or variable interest rates. Variable rates can appear lower when comparing both options, but there's always the chance they could rise, bringing up the cost of monthly payments as well.

Additionally, while student loans usually charge simple interest as opposed to compound interest, that may not always be the case with private loans.

“Most of your private loans stick with that simple interest model, but it's impossible to speak to every private loan out there,” says Brandon Barfield, director and co-founder of Student Loan Professor, and a former financial aid supervisor at Kaplan University.

How to reduce the amount of interest you pay

If you're worried about just how much interest charges can drive up the amount you ultimately repay on your loan, know that there are ways to minimize them. These include:

• Make interest payments while in school: With the exception of subsidized federal loans, interest generally starts to accrue on student loans as soon as they are disbursed — even while you're still in school. By making interest-only payments during that time, you can cut down on the amount of interest that gets added to your loan, potentially saving you significantly in the long run.
• Pay extra toward the principal to lower total interest costs: Another way to save on interest is to put extra money toward paying down your loan's principal. This way, your loan's interest charges are lower since they're calculated on a lower principal balance.
• Refinance for a lower interest rate: You also can pay less in interest if you secure a lower interest rate than you currently have. If your credit score and other financial factors have improved since you first took out your loan, you may be able to land a more competitive rate through student loan refinancing.
• Shorten your repayment timeline: Another simple way to reduce the amount of interest you pay is to opt for a shorter repayment term. “If you look at amortization tables for how much you'd pay under a 20-year versus a 5- or 10-year loan, a longer-term loan has a lot more interest built into it,” says Barfield. “A 25-year plan will usually cost you double what you borrowed to get that degree,” he notes, whereas “with a 10-year standard payment plan, interest is usually half of what was borrowed in total payments.”

What happens if you don't pay student loan interest?

While in school, you generally don't need to make payments on your student loans (though some private lenders require immediate repayment). Even so, during that period, interest will accrue on your loan, starting from when the funds are disbursed. (The exception is if you have a federal subsidized loan, in which case the Department of Education will pay the interest on your loan while you're in school at least half-time, as well as during your grace period and any other periods of deferment).

As such, if you don't make interest payments while in school, that unpaid interest will capitalize when your loan enters repayment, ballooning your loan's total balance.

“Depending on the interest rate, this means that the loan balance will be 20% to 30% higher when the loan enters repayment,” says Mark Kantrowitz, author of “How To Appeal for More College Financial Aid.”

If you fail to make student loan interest payments when you enter repayment, that can lead to even more serious consequences.

“Loan payments are applied first to interest and second to principal. So, if you don't make payments of interest during the repayment term, you're also not making payments of principal, so your loan payments are delinquent,” says Kantrowitz.

If your loans remain delinquent due to a continued failure to make payments, they'll enter default. This can lead to consequences such as loss of federal aid eligibility, damage to your credit score, wage garnishment, and debt collection.