Updated: Apr 3
Most federal student loans are currently in forbearance and you likely have not visited the studentaid.gov loan calculator for a while. How well did you understand your loan obligations when you signed on the dotted line and took out your student loans?
We are getting close to the end of the CARES Act and payments will resume soon. You may be wondering how much you still owe and may be asking yourself: How does student loan interest work? Understanding how student loan interest works is crucial to personal debt management. Let's begin by answering the following questions:
How does interest on student loans work?
What is the formula for calculating student loan interest?
How is student loan interest calculated?
What happens if you don't make your monthly payments in full?
What happens if you make extra payments on your student loans?
What does interest on a student loan mean to me?
We will walk you through the ins and outs of student loan interest, including how interest rates are set, how interest accrues, and how payments are split between your main balance and interest charges.
1. How does student loan interest work?
When a new student loan is issued, the borrower is required to sign a promissory note that describes the loan's terms. This agreement must be read and understood in its entirety, as it affects how much you owe and when your payments are due. This also applies to parent PLUS (Parent Loans for Undergraduate Students) loans and interest.
The most important terms to look out for are:
Disbursement date: The date the funds arrive, and interest begins to accrue
Amount borrowed: The total amount borrowed in each loan
Interest rate: How much you must pay to borrow the funds
How interest accrues: Whether interest is charged daily or monthly
How interest capitalizes: When accrued interest is capitalized (or added) to your principal balance
First payment date: When you must make your first loan payment
Payment schedule: How many payments you are required to complete
2. When does interest start on student loans?
For students that demonstrate need, the government offers subsidized direct loans. If you qualify, the government pays your interest while you’re in school, so your balance doesn’t grow. The Department of Education recognizes that most full-time students do not have a source of income, and even if they do, it is insufficient to make payments. Once you graduate, though, the interest becomes your responsibility.
Unsubsidized loans, on the other hand, charge interest from the moment they are disbursed. Because you are not required to make payments, interest will accrue, and you will graduate with a larger loan balance than when you began.
Unfortunately, there are no subsidized loans for parents. Additionally, regular repayment begins immediately after the loan is completely disbursed (unless you request a deferment).
3. How is student loan interest calculated?
Each month, your required loan payment will be the same. When you make a payment, however, interest is paid first, followed by principal reduction. Your remaining payment will be added to your principal balance.
To calculate your "interest rate factor," divide your interest rate by the number of days in the year. The loan sum is then multiplied by the interest rate factor, which is then multiplied by the number of days since your previous payment. The amount of interest you will be charged for that period is the result.
What about fixed and variable interest rates?
Federal student loans: The Department of Education exclusively uses fixed interest rates, which are determined annually by Congress. Unless you refinance your federal loans to a cheaper rate, fixed rates will remain the same over time.
Lenders usually provide fixed or variable interest rates on private loans, and variable rates fluctuate over time, making them a riskier prospect for borrowers. Some online lenders even offer hybrid rates, which combine fixed and variable rates in one package.
4. How is student loan interest applied?
Your balance and the amount of interest you pay on your student loan will decrease as you make payments. More of your payments are applied to your principle when interest rates are lower.
Your monthly interest payment will decrease during the life of your loan, accelerating your principal payoff. That's how student loan amortization works, which is just a fancy way of saying "paying down the principal on a loan." Remember, your payment amount goes toward interest and any outstanding fees before it reduces your principal.
If you have an unsubsidized loan or have reached the end of the subsidy period, you a required to make the same minimum payment every month until the loan is paid off. Interest continues to accrue if you are on a payment plan or if you have deferred payments. This amount is added to your principal, bringing your total student loan debt to a higher level.
It may make sense to pay at least the interest each month if you are able. If you don't, your loan balance will grow, and you will be charged interest on the interest you did not pay in the past months.
Making interest payments while you're in school can save you money overall (or eventually) if you have the means When it comes to interest on a parent PLUS loan, the difference is even more pronounced. Assume you borrow $5,000 in parent PLUS loans for each year your child attends school. With a 7% interest rate, here's how the interest accumulates:
Sallie Mae's accumulated interest calculator was used to make these calculations, which presume the current federal rate on parent PLUS loans will remain unchanged for the next four years. It also anticipates that you will continue to accrue interest on your child's freshman year loan for four years, three years on the sophomore loan, two years on the junior year loan, and 12 months on the final loan. As you can see, you borrowed $20,000, but if you wait until your child graduates from college to pay it back, your loan balance will rise to $23,500.
5. What happens if you don’t make full payments each month?
It's crucial to know that making partial payments will appear on your credit report as a missed or delinquent payment, potentially putting you in default.
If you're having trouble making payments and can't seem to find a solution, consider an income-driven repayment plan. For example, the REPAYE (Revised Pay As You Earn) program limits your contributions to 10% of your discretionary income.
How are extra student loan payments treated?
When you make your monthly payment, you’re given the option to pay extra. If you do, that extra payment is applied directly to the principal, which will reduce your interest in the future.
Any other extra payments made throughout the month are treated as normal payments. That is, your payment is first applied to interest you accrued since your last payment and then your principal. Double-check your lender’s payment policies to make sure any extra payments are really going to pay down your principal.
Don’t underestimate the power of early student loan payments. Paying an extra $50 or $100 each month can save you thousands of dollars in interest, depending on your loan terms. Check out the student loan prepayment calculator to see how much you can save by paying a little more every month.
What does student loan interest mean to me?
If you put off payments or only pay the minimum each month, you'll end up paying a lot of interest throughout the life of the loan.
Use your new knowledge understanding of how to calculate student loan interest and compound interest to pay off your debts sooner.
You put forth a lot of effort to get each paycheck. Pay more now to save later.
Have any questions regarding your upcoming payment, or other payment options?
Contact TitanPrep today.