Back when you signed the dotted line and took out your student loans, how well did you understand the terms? Maybe things were a little fuzzy, but you knew you needed the loans to pay for college.
Student loan interest is one of the more complicated aspects of student loans. How interest rates are set, how interest accrues, and how payments are divided between your principal balance and interest charges can be difficult to grasp.
But understanding how student loan interest works is an important step in managing your debt.
How does student loan interest work?
When new student loans are issued, the borrower signs a promissory note that explains the terms of the loan. Every part of this document is important to read and understand, as it determines how much you owe and when your payments are due.
The most important terms to look out for are:
- Issue date: The date your loan starts to accrue interest
- Amount borrowed: The total amount borrowed in each loan
- Interest rate: How much you have to pay to borrow the funds
- How interest accrues: Whether interest is charged daily or monthly
- First payment date: When you have to make your first loan payment
- Payment schedule: How many payments you have to make
Lenders understand that most full-time students do not have an income, and if they do, it is not enough to cover student loan payments while in school. Because of that, many student loans are subsidized by the federal government. That means you do not accrue interest while still in school.
Unsubsidized loans, meanwhile, charge interest from the day the loan is issued.
Why is this important? Knowing whether your loans are subsidized or unsubsidized tells you if your balances will grow while you’re in school.
How is student loan interest calculated?
Your required loan payment will be the same each month. However, when you make a payment, interest is paid first. The remainder of your payment is applied to your principal balance.
Student loan interest is typically compounded daily. That means your interest rate is divided by the number of days in the year and you are charged each day based on the outstanding balance.
To understand how compound interest works, let’s look at an example. Consider a Direct loan with a $10,000 balance and a 4.29% interest rate.
If this loan were compounded annually, 4.29% of the loan balance would be charged each year. In this case, the interest would be $429 per year.
If your loan compounds daily, you’ll instead be charged interest every day. Your 4.29% interest rate will be divided by 365. That comes out to 0.0118% of interest each day. Assuming a $10,000 balance, that is $1.175 per day.
If you make your payment on the regular schedule once per month, the interest you accrued over the month is added up. Your payment is applied to that accrued interest, which comes out to about $35 in our example. The rest of your payment lowers your outstanding principal balance.
How is student loan interest applied?
As you make payments on your student loan, your balance and the amount of interest you accrue will drop. With lower interest charges, more of your payments are applied to your principal. Over the life of your loan, your interest paid will decline each month, which accelerates your principal payment. That’s how amortization works.
Remember, interest is always paid first. If you have an unsubsidized loan or are past the subsidy period, your loan payoff date requires you to make the same minimum payment each month. If you are on a payment plan or have deferred payments, interest will continue to accrue. This amount is added to your principal, increasing your student loan balance.
If you are able, you should always pay at least the interest each month. If you don’t, your loan balance will continue to grow and you will owe interest on the interest you didn’t pay in previous months.
Further, making partial payments will count as a missed or late payment on your credit report and may cause you to go into loan default, which is not a good thing.
If you are struggling to make payments and can’t figure out a way to afford them, you can look into an income-driven repayment plan. The REPAYE program, for example, limits your payments to 10 percent of your discretionary income.
This loan payment calculator can quickly tell you how much of your payments are going toward interest and principal each year.
How are extra student loan payments treated?
When you make your monthly payment, you are 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.
Don’t underestimate the power of early 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.
When I was still making student loan payments, I lived on a budget that allowed me to make a full payment each payday. Paying double each month helped me pay down my balances quickly, and I was able to make my final payment exactly two years and six days after graduation.
Compound interest is a powerful weapon
As some believe Albert Einstein once said, “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”
Putting off payments or just making the minimum each month will leave you with a big interest cost over the life of your loan.
Use your new knowledge of compound interest to pay off your loans early. You work hard for each paycheck. Pay more today so you can save big later.
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