Do Student Loans Have Interest? How It Works

Student loans accrue interest, the cost charged by a lender for borrowing money. This amount is a percentage of the unpaid principal balance and is paid back over the loan’s life.

Types of Student Loan Interest

Student loans have different interest rates and accrual methods that impact the total amount repaid. A fixed interest rate remains constant throughout the loan’s term, providing predictable monthly payments. In contrast, a variable interest rate can fluctuate based on market conditions, potentially leading to changes in monthly payment amounts over time. While federal student loans exclusively offer fixed rates, private student loans may come with either fixed or variable rates.

Subsidized and unsubsidized loans also differ regarding interest. For Direct Subsidized Loans, the government pays the interest while the borrower is enrolled in school at least half-time, during the grace period, and during periods of deferment. Unsubsidized loans, however, accrue interest from the moment they are disbursed, with the borrower responsible for all accrued interest.

Most federal student loans and many private loans use simple interest, meaning interest is calculated solely on the original principal balance. However, when unpaid interest is added to the principal balance, a process known as capitalization, it effectively results in interest being charged on interest, similar to compound interest. Capitalization increases the loan’s principal, leading to higher interest charges over time.

When Interest Begins to Accrue

The timing of interest accrual depends on the type of student loan. For unsubsidized federal loans and most private student loans, interest begins accumulating immediately from the date the loan funds are disbursed. For Direct Subsidized Loans, interest is covered by the government during specific periods, including while the borrower is in school at least half-time, during the grace period, and during deferment.

A grace period, six months after leaving school or dropping below half-time enrollment, precedes the start of repayment. Interest begins to accrue after this period ends for loans where the government previously paid the interest. For unsubsidized loans, interest continues to accrue. During periods of deferment or forbearance, interest continues to accrue on all loan types, except for subsidized loans during deferment. Unpaid interest accrued during forbearance or deferment periods for unsubsidized loans can be capitalized, increasing the principal balance.

Calculating Student Loan Interest

Student loan interest is calculated daily using a simple interest formula. This calculation involves multiplying the current principal balance by the loan’s interest rate factor, which is the annual interest rate divided by 365. For example, a $10,000 loan with a 5% interest rate would accrue approximately $1.37 in interest per day ($10,000 x 0.05 / 365).

When a payment is made on a student loan, the funds are applied in a specific order: first to any outstanding fees, then to accrued interest, and finally to the principal balance. This application method means that early in the repayment period, a larger portion of each payment often goes toward covering interest rather than reducing the principal. Making extra payments or paying interest during periods when payments are not required, such as while in school or during grace periods, can reduce the total interest paid over the loan’s lifetime. This is because reducing the principal balance earlier means less interest accrues on a smaller amount.

Student loans are amortized, meaning they are repaid through a series of equal monthly installments over a set period. As the loan balance decreases over time, the proportion of each payment allocated to interest gradually lessens, and a larger portion is applied to the principal. This amortization schedule ensures the loan is paid off by the end of the term, with the amount of interest paid decreasing as the principal balance is reduced.