The Truth About Student Loans: What You Borrow Isn’t What You’ll Pay

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With the cost of college on the rise, it’s little surprise that student loan debt is on the rise, too. In fact, there’s a good chance you’ll need to borrow in order cover the cost of your higher education — and it wouldn’t be unreasonable to expect to owe $30,000 after earning your bachelor’s degree.

But just because you borrow $30,000, it doesn’t mean that’s what you’ll repay. Student loan interest rates mean that your final cost could be more than what you expect. Before you sign on the dotted line, it’s important to know what you’re getting into.

How is student loan interest calculated?

“Anytime you borrow money, no matter what it’s for, you are probably going to pay interest,” said Tom Drake, a financial analyst and the founder of Maple Money, a financial education website. “It’s the price you pay for the privilege of borrowing. The lender expects a premium for providing you with the funds you need.”

Drake pointed out that student loan interest is usually lower than other types of unsecured debt, like credit cards and personal loans from banks. However, he said, “even at lower rates, the amounts you borrow to pay for school can mean that you pay thousands of dollars extra in interest.”

How is student loan interest compounded?

Student loan interest rates are expressed as an annual percentage rate. Federal rates are set by Congress each year. Private student loan rates are set by lenders based on financial market rates, particularly what is happening with the London Interbank Offered Rate (LIBOR), a benchmark interest rate used as a reference for many types of loans.

Each year, you have a new student loan that might have a different interest rate, especially on federal loans. At the end of your time in school, you’ll repay your federal loans based on an average interest rate.

You might see a rate of 4.45% for federal loans, but find possibilities ranging from 2.50% (or lower) to 11.85% (or higher) on private loans. In the end, what rate you get with a private student loan depends on a variety of factors, including your credit history. Your federal loan rate, though, is the same no matter your credit history or other circumstances.

Even though student loan rates are expressed as an annual rate, the interest is usually compounded daily. On a $10,000 loan, you might think that a 4.45% interest rate would mean $445 paid in interest during the year, but that’s not the case.

Instead, your annual rate is divided by 365, to get your daily interest rate. So, in the above example, you’d be charged an interest rate of 0.012% each day. At the end of your first day, your interest charge totals $1.20 and it’s added to the $10,000. On the following day, your interest is calculated on $10,001.20. At the end of the year, you’ll pay a total of $455.02 in interest — providing the lender with an extra $10 just because of the way interest is compounded.

When you consider that this daily compounding takes place over all the years you are in school and beyond, you can see how interest charges lead to repaying so much more than you borrow.

Subsidized vs. unsubsidized federal loans

First, you need to know what types of loans you have. For all loans, interest begins accruing as soon as the loan is disbursed. However, you might not be responsible for paying that interest.

When you have a subsidized student loan, the government pays your interest while you’re in school (as long as you are enrolled at least half-time) and during a six-month grace period following your graduation. As a result, your balance after you leave school would be the same as the amount you received in loans.

But the story is different with unsubsidized loans. “Because the government isn’t paying your interest, it accrues and is added to your balance,” explains Katie Brewer, a Certified Financial Planner at advisory firm Your Richest Life. “Your balance grows the whole time you’re in school, and you’ll pay interest on the total amount when you finish.”

Let’s take a look at what happens if you borrow the maximum amount in unsubsidized federal loans each year:

how is student loan interest compounded

The chart assumes that the current 4.45% interest rate on federal loans will hold steady throughout your entire four years. It also assumes that you will accrue interest on your freshman year loans for four years, your sophomore year for three, your junior for two, and your senior year for 12 months.

When you borrow the federal maximum for four years, you end up with $27,000 in student loans. However, you’re also on the hook for $2,849 in interest. When you graduate, you actually owe $29,849. And, of course, the interest keeps piling up during your grace period. When you finally start repaying your loans, you’re looking at more than $30,000 in debt — even though you didn’t borrow that much.

If you have some subsidized loans, though, you might not owe as much, thanks to the government covering your interest charges.

Private student loans

You see a similar story with private student loans, said Drake. Check with your lender to see if there is a grace period after graduation, as well as the ability to put off payments until you finish school. But either way, you’ll still have to watch rates, and realize your balance could grow while you’re getting your education.

“Your student loan interest rates might be higher or lower, and they might be more sensitive to market movements,” Drake said. “Pay attention because you could see your rates rise rapidly, and that could make a big difference later.”

No matter what type of loan you get, Brewer recommended at least paying interest while you’re in school. “It’s possible to make payments on your loans before you graduate, whether you have federal loans or private loans,” she said. “You can save thousands of dollars over the life of your loan just by paying interest during school and while you’re in your grace period.”

How much do you pay back on student loans?

Once you finish your bachelor’s degree and start repaying your loans, interest is still a part of the equation. Let’s say that by the time your accrued interest is added to the original amount you borrowed, you have $30,000 in student debt. With an interest rate of 4.45%, and a standard 10-year repayment, you can see how much you’re likely to owe using the student loan interest rate calculator from Student Loan Hero:

As you can see, over the course of 10 years, you end up paying more than $7,000 in interest. Lengthening your loan term or choosing a repayment plan other than the standard one could lead to even greater repayment amounts.

Take a look at the student loan interest calculator and estimator from the Department of Education. You can see the impact of different repayment plans, including five types of “income-driven repayment” options, which can offer a lower monthly repayment based on how much you earn. (The example below uses an income of $51,022, which is the average starting salary for the class of 2017, according to the National Association of Colleges and Employers.)

how much do you pay back on student loan

Image credit: The Department of Education

All of these plans assume that you are single and will repay your loan within 10 years. If you start with a lower monthly payment to maintain better cash flow, you could see some higher amounts. However, if you work in a qualifying job and take advantage of Public Service Loan Forgiveness (PSLF), you could save money on your student loans, depending on the plan you choose.

But what happens if you don’t use PSLF and you have a lower income? Say you make $35,000 a year, so your income-driven repayment is spread out beyond 10 years. Depending on the plan, you could wind up repaying almost $44,000 over the course of a little more than 15 years.

student loan interest rates

Image credit: The Department of Education

What if you are concerned about cash flow and you decide to refinance to a 20-year term? You could end up paying even more, with a quarter of your total repayment going to cover the interest.

You pay less on a monthly basis, but there’s a hefty price for that improved cash flow.

If you really want to reduce what you pay on your debt, refinancing to a lower interest rate and a shorter term can be the way to go. For borrowers that can qualify for a better interest rate and can handle a higher monthly payment, it’s possible to save thousands of dollars in interest.

student loan interest rates

Finding the best student loan interest rates

No matter what you do, your final bill will be more than what you borrowed. That’s just the nature of debt. However, you can reduce what you end up paying by looking for the best student loan rates.

Initially, there’s nothing you can do about federal student loan rates because Congress sets the rates. Once you finish school, though, you can refinance to private loans to save money during repayment — as long as you aren’t planning on applying for PSLF or depending on for the protections that come with federal loans.

In some cases, taking private student loans is a better choice than starting with federal loans. Carefully consider your situation and weigh the pros and cons to see if you can benefit from a lower rate on a private student loan.

Qualifying for a private student loan or a refinance isn’t always easy, though. You need to have good credit and income. If you can’t get a private loan on your own, you might need a cosigner.

Of course, it’s best if you reduce how much you need to borrow in the first place, said Brewer. “Start with scholarships and see if you qualify for grants,” she said. “Then, look into work-study programs or consider getting a part-time job. The less you end up borrowing, the better off you’ll be financially when you graduate.”

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Our team at Student Loan Hero works hard to find and recommend products and services that we believe are of high quality and will make a positive impact in your life. We sometimes earn a sales commission or advertising fee when recommending various products and services to you. Similar to when you are being sold any product or service, be sure to read the fine print understand what you are buying, and consult a licensed professional if you have any concerns. Student Loan Hero is not a lender or investment advisor. We are not involved in the loan approval or investment process, nor do we make credit or investment related decisions. The rates and terms listed on our website are estimates and are subject to change at any time. Please do your homework and let us know if you have any questions or concerns.