How Is Interest Charged on Student Loans?

Student loans are a common financial tool for pursuing higher education. Understanding how interest works on these loans is fundamental for managing educational debt effectively. Interest represents the cost of borrowing money, calculated as a percentage of the outstanding principal balance. This additional cost significantly impacts the total amount repaid over the life of the loan. Comprehending the mechanics of student loan interest allows borrowers to make informed decisions about their repayment strategies.

Understanding Student Loan Interest

Interest on student loans is the fee paid to a lender for the use of borrowed funds. This cost is expressed as an annual percentage rate (APR) and is applied to the loan’s principal balance. Student loans can have either fixed or variable interest rates.

A fixed rate remains constant throughout the loan’s life, offering predictable monthly payments. A variable rate can fluctuate based on market conditions, potentially changing monthly payments and the total loan cost. Federal student loans feature fixed rates, while private student loans may offer both.

Interest on most student loans accrues daily. This means a small amount of interest is calculated each day on the outstanding principal balance, known as simple daily interest. To calculate the daily interest charge, the annual interest rate is divided by 365, then multiplied by the current principal balance. For instance, a $10,000 loan with a 5% annual interest rate accrues $1.37 in interest per day ($10,000 x 0.05 / 365).

Interest Capitalization

Interest capitalization occurs when accrued but unpaid interest is added to the loan’s principal balance. This increases the total amount owed, as future interest calculations are based on this new, higher principal. This effect, often called “interest on interest,” leads to a greater overall repayment cost and potentially higher monthly payments.

Capitalization commonly happens at the end of a grace period, for unsubsidized loans after periods of deferment or forbearance, or when borrowers change certain repayment plans if payments have not covered all accruing interest.

Paying accruing interest before it capitalizes can prevent the loan balance from growing larger than the original amount borrowed, reducing the total interest paid over the loan’s lifetime.

Interest and Loan Types

The way interest is handled differs between student loan types, influencing the borrower’s total cost. Federal student loans are categorized into subsidized and unsubsidized loans, with distinct rules for interest accrual. Subsidized federal loans do not accrue interest while the student is enrolled in school at least half-time, during the grace period, or during periods of deferment. The government covers this interest during these specific periods.

Unsubsidized federal loans accrue interest from the moment the funds are disbursed, regardless of enrollment status or grace periods. Borrowers are responsible for all accrued interest on unsubsidized loans. Private student loans, offered by banks or other financial institutions, accrue interest from disbursement, and their interest rates are determined by factors like the borrower’s creditworthiness and can be fixed or variable. Federal loan interest rates are set by federal law and are fixed for the life of the loan.

When making payments, student loan servicers apply funds in a specific order. Payments are first applied to any outstanding fees, then to accrued interest, and finally to the principal balance of the loan. If a payment is not sufficient to cover all accrued interest, the remaining interest accumulates. Making payments beyond the minimum due can help reduce the principal balance more quickly, reducing the amount of interest that accrues over time.

Interest During Special Circumstances

Student loan interest behavior changes during periods when borrowers are not required to make payments. During the grace period, interest accrues on unsubsidized federal and private loans. This accrued interest capitalizes when repayment begins. Subsidized federal loans do not accrue interest during their grace period.

Deferment allows a temporary pause in loan payments due to circumstances like returning to school or economic hardship. For subsidized federal loans, interest does not accrue during deferment. For unsubsidized federal loans and private loans, interest accrues during deferment and typically capitalizes at the end of the deferment period.

Forbearance offers a temporary payment suspension, but interest always accrues on federal and private loans during this period. This accrued interest capitalizes at the conclusion of the forbearance. For borrowers on income-driven repayment (IDR) plans, interest can also accrue and potentially capitalize if their monthly payments are too low to cover the full amount of interest, particularly on unsubsidized loans.