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. Or maybe you’re a parent who wanted to help your child pay for an education and a better future. Now you’re wondering how much you’ll have to pay back on your Parent PLUS loans and you’re asking yourself: how does interest work?.
Whether you paid for your education or helped your child, interest rates are 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. This applies to Parent PLUS loans and their interest as well.
The most important terms to look out for are:
- Disbursement date: The date the funds arrive and interest starts accruing
- 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. As a result, it’s often possible to avoid making payments while you’re in school.
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. Once you graduate, though, the interest becomes your responsibility.
Unsubsidized loans, meanwhile, charge interest from the day the loan is disbursed. Since you aren’t required to make payments, interest will build up, and you’ll graduate with a loan balance higher than you started with.
Do Parent PLUS loans accrue interest the same way? Unfortunately, there are no subsidized loans for parents. Additionally, regular repayment begins 60 days after the loan is completely disbursed.
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 before any money goes toward reducing your principal. The remainder of your payment is applied to your principal balance.
Your interest rate is divided by the number of days in the year to get your “interest rate factor.” The interest rate factor is then multiplied by your loan balance and then multiplied by the number of days since your last payment. The result is how much interest you are charged for that period.
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 it works with amortization — basically a fancy way of saying “paying down 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 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 continues to accrue. This amount is added to your principal, increasing your student loan balance.
If you are able, it can make sense to 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.
In fact, if you have the ability, making interest payments while you are in school can save you money in the long run.
The difference is even more pronounced when you think of interest paid on a Parent PLUS loan. Let’s say you take $5,000 in Parent PLUS loans each year your child is in school. Here’s how the interest builds up with a 7% interest rate:
These calculations were made using Sallie Mae’s accrued interest calculator and assumes the current federal rate on Parent PLUS loans will hold for four years. It also assumes you will keep accruing interest for four years on your child’s freshman year loan, three years on the sophomore loan, two years for the junior year, and 12 months on the final loan.
As you can see, you borrowed $20,000, but if you put off repayment until after your child graduates from college, your loan balance will grow to $23,500.
What happens if you don’t make full payments each month?
It’s important to remember that making partial payments will count as a missed or late payment on your credit report and may cause you to go into loan default.
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.
Using Student Loan Hero’s Income-Based Repayment calculator, you can see how it can help with your monthly cash flow. However, you have to watch out: Interest remains a factor, and the longer you are subject to interest charges, the more you repay in the end.
The example above assumes you have an adjusted gross income of $30,000, that your income rises 3.5 percent each year, and that you have $30,000 in federal student loan debt at an average interest rate of 4.26%.
And what happens if you defer your student loan payments? Consider your Parent PLUS loans. Our student loan deferment calculator can help you figure out how much extra you pay if, for example, you have $20,000 in debt at 7% and defer for 12 months.
As you can see, deferment adds $1,400 to the total when you’re on a 10-year repayment.
While it is possible for you to defer payments when you have a Parent PLUS loan, the fees and interest might mean it makes more sense to avoid it if you can make room in your budget to keep paying down your debt, or even looking into refinancing at a lower interest rate if possible.
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. 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 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.
Compound interest is a powerful weapon
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 how to calculate interest on a loan and how compound interest works to pay off your loans early. You work hard for each paycheck. Pay more today so you can save even bigger later.
Eric Rosenberg and Christy Rakoczy contributed to the reporting for this article.contributed to this article.
*Sallie Mae Disclaimer: Click here for important information. Terms, conditions and limitations apply.
†The Sallie Mae partner referenced is not the creditor for these loans and is compensated by Sallie Mae for the referral of Smart Option Student Loan customers.
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1 Important Disclosures for Laurel Road.
Laurel Road Disclosures
All credit products are subject to credit approval.
Laurel Road began originating student loans in 2013 and has since helped thousands of professionals with undergraduate and postgraduate degrees consolidate and refinance more than $4 billion in federal and private school loans. Laurel Road also offers a suite of online graduate school loan products and personal loans that help simplify lending through customized technology and personalized service. In April 2019, Laurel Road was acquired by KeyBank, one of the nation’s largest bank-based financial services companies. Laurel Road is a brand of KeyBank National Association offering online lending products in all 50 U.S. states, Washington, D.C., and Puerto Rico. All loans are provided by KeyBank National Association, a nationally chartered bank. Member FDIC. For more information, visit www.laurelroad.com.
As used throughout these Terms & Conditions, the term “Lender” refers to KeyBank National Association and its affiliates, agents, guaranty insurers, investors, assigns, and successors in interest.
Assumptions: Repayment examples above assume a loan amount of $10,000 with repayment beginning immediately following disbursement. Repayment examples do not include the 0.25% AutoPay Discount.
Annual Percentage Rate (“APR”): This term represents the actual cost of financing to the borrower over the life of the loan expressed as a yearly rate.
Interest Rate: A simple annual rate that is applied to an unpaid balance.
Variable Rates: The current index for variable rate loans is derived from the one-month London Interbank Offered Rate (“LIBOR”) and changes in the LIBOR index may cause your monthly payment to increase. Borrowers who take out a term of 5, 7, or 10 years will have a maximum interest rate of 9%, those who take out a 15 or 20-year variable loan will have a maximum interest rate of 10%.
KEYBANK NATIONAL ASSOCIATION RESERVES THE RIGHT TO MODIFY OR DISCONTINUE PRODUCTS AND BENEFITS AT ANY TIME WITHOUT NOTICE.
This information is current as of June 23, 2020. Information and rates are subject to change without notice.
2 Important Disclosures for Splash Financial.
Splash Financial Disclosures
Splash Financial loans are available through arrangements with lending partners. Your loan application will be submitted to the lending partner and be evaluated at their sole discretion. For loans where a credit union is the lender, or a purchaser of the loan, in order to refinance your loans, you will need to become a credit union member.
The Splash Student Loan Refinance Program is not offered or endorsed by any college or university. Neither Splash Financial nor the lending partner are affiliated with or endorse any college or university listed on this website.
You should review the benefits of your federal student loan; it may offer specific benefits that a private refinance/consolidation loan may not offer. If you work in the public sector, are in the military or taking advantage of a federal department of relief program, such as income based repayment or public service forgiveness, you may not want to refinance, as these benefits do not transfer to private refinance/consolidation loans.
Splash Financial and our lending partners reserve the right to modify or discontinue products and benefits at any time without notice. To qualify, a borrower must be a U.S. citizen and meet our lending partner’s underwriting requirements. Lowest rates are reserved for the highest qualified borrowers. This information is current as of May 1, 2020.
Fixed APR: Annual Percentage Rate [APR] is the cost of credit calculating the interest rate, loan amount, repayment term and the timing of payments. Fixed Rate options range from 2.88% (without autopay) to 7.27% (without autopay) and will vary based on application terms, level of degree and presence of a co-signer. Rates are subject to change without notice. Fixed rate options without an autopay discount consist of a range from 2.88% per year to 6.21% per year for a 5-year term, 3.40% per year to 6.25% per year for a 7-year term, 3.45% to 5.08% for a 8-year term, 3.89% per year to 6.65% per year for a 10-year term, 4.18% per year to 5.11% per year for a 12-year term, 4.20% per year to 7.05% per year for a 15-year term, or 4.51% per year to 7.27% per year for a 20-year term, with no origination fees. The fixed interest rate will apply until the loan is paid in full (whether before or after default, and whether before or after the scheduled maturity date of the loan).
Variable APR: Annual Percentage Rate [APR] is the cost of credit calculating the interest rate, loan amount, repayment term and the timing of payments. Variable rate options range from 1.99% (with autopay) to 7.10% (without autopay) and will vary based on application terms, level of degree and presence of a co-signer. Our lowest rate option is shown with a 0.25% autopay discount. Our highest rate option does not include an autopay discount. The variable rates are based on the Variable rate index, is based on the one-month London Interbank Offered Rate (“LIBOR”) published in The Wall Street Journal on the twenty-fifth day, or the next business day, of the preceding calendar month. As of April 27, 2020, the one-month LIBOR rate is 0.43763%. The interest rate on a variable rate loan is comprised of an index and margin added together. The margin is a fixed amount (disclosed at the time of your loan application) added each month to the index to determine the next month’s variable rate. Variable rate options without an autopay discount consist of a range from 2.01% per year to 6.30% per year for a 5-year term, 4.00% per year to 6.35% per year for a 7-year term, 2.09% per year to 3.92% per year for a 8-year term, 4.25% per year to 6.40% per year for a 10-year term, 2.67% per year to 4.56% per year for a 12-year term, 3.44% per year to 6.65% per year for a 15-year term, 4.75% per year to 6.93% per year for a 20-year term, or 5.14% per year to 7.10% for a 25-year term, with no origination fees. APR is subject to increase after consummation. Variable interest rates will fluctuate over the term of the borrower’s loan with changes in the LIBOR rate, and will vary based on applicable terms, level of degree earned and presence of a co-signer. The maximum variable rate may be between 9.00% and 16.00%, depending on loan term. The floor rate may be between 0.54% and 4.21%, depending on loan term. These rates are subject to additional terms and conditions, and rates are subject to change at any time without notice. Such changes will only apply to applications taken after the effective date of change.
3 Important Disclosures for SoFi.
4 Important Disclosures for Earnest.
To qualify, you must be a U.S. citizen or possess a 10-year (non-conditional) Permanent Resident Card, reside in a state Earnest lends in, and satisfy our minimum eligibility criteria. You may find more information on loan eligibility here: https://www.earnest.com/eligibility. Not all applicants will be approved for a loan, and not all applicants will qualify for the lowest rate. Approval and interest rate depend on the review of a complete application.
Earnest fixed rate loan rates range from 3.19% APR (with Auto Pay) to 6.43% APR (with Auto Pay). Variable rate loan rates range from 1.99% APR (with Auto Pay) to 6.43% APR (with Auto Pay). For variable rate loans, although the interest rate will vary after you are approved, the interest rate will never exceed 8.95% for loan terms 10 years or less. For loan terms of 10 years to 15 years, the interest rate will never exceed 9.95%. For loan terms over 15 years, the interest rate will never exceed 11.95% (the maximum rates for these loans). Earnest variable interest rate loans are based on a publicly available index, the one month London Interbank Offered Rate (LIBOR). Your rate will be calculated each month by adding a margin between 1.82% and 5.50% to the one month LIBOR. The rate will not increase more than once per month. Earnest rate ranges are current as of June 15, 2020, and are subject to change based on market conditions and borrower eligibility.
Auto Pay discount: If you make monthly principal and interest payments by an automatic, monthly deduction from a savings or checking account, your rate will be reduced by one quarter of one percent (0.25%) for so long as you continue to make automatic, electronic monthly payments. This benefit is suspended during periods of deferment and forbearance.
The information provided on this page is updated as of 6/15/2020. Earnest reserves the right to change, pause, or terminate product offerings at any time without notice. Earnest loans are originated by Earnest Operations LLC. California Finance Lender License 6054788. NMLS # 1204917. Earnest Operations LLC is located at 302 2nd Street, Suite 401N, San Francisco, CA 94107. Terms and Conditions apply. Visit https://www.earnest.com/terms-of-service, email us at [email protected], or call 888-601-2801 for more information on our student loan refinance product.
© 2020 Earnest LLC. All rights reserved. Earnest LLC and its subsidiaries, including Earnest Operations LLC, are not sponsored by or agencies of the United States of America.
5 Important Disclosures for CommonBond.
Offered terms are subject to change. Loans are offered by CommonBond Lending, LLC (NMLS # 1175900). If you are approved for a loan, the interest rate offered will depend on your credit profile, your application, the loan term selected and will be within the ranges of rates shown. All Annual Percentage Rates (APRs) displayed assume borrowers enroll in auto pay and account for the 0.25% reduction in interest rate. All variable rates are based on a 1-month LIBOR assumption of 0.19% effective June 10, 2020.