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If you’ve recently graduated or dropped out of college, you might be surprised how much of your student loan payment goes to just the interest portion of your debt. To understand why, you must first understand how this interest accrues and how it is applied to each payment.
Key points to remember
- Federal loans use a simple interest formula to calculate your finance charge; however, some private loans use compound interest, which increases your interest costs.
- Some private student loans have variable interest rates, which means you can pay more or less interest at a later date.
- With the exception of subsidized federal loans, interest generally begins to accrue when the loan is disbursed.
3 steps to calculate your student loan interest
Figuring out how lenders charge interest for a given billing cycle is actually quite simple. All you have to do is follow these three steps:
Step 1. Calculate the daily interest rate
You first take the annual interest rate of your loan and divide it by 365 to determine the amount of daily accrued interest.
Let’s say you owe $10,000 on a loan with 5% annual interest. You would divide this rate by 365 (0.05 ÷ 365) to arrive at a daily interest rate of 0.000137.
Step 2. Identify your daily interest charges
You then multiply your daily interest rate from Step 1 by your outstanding principal of $10,000 (0.000137 x $10,000) to determine the amount of interest assessed to you each day. In this case, you are charged interest of $1.37 daily.
Step 3. Convert it to a monthly amount
Finally, you will need to multiply this daily interest amount by the number of days in your billing cycle. In this case, we’ll assume a 30-day cycle, so the amount of interest you’ll pay for the month is $41.10 ($1.37 x 30). The total for one year would be $493.20.
Interest begins to accrue like this from the time your loan is disbursed, unless you have a subsidized federal loan. In this case, you don’t pay interest until the end of your grace period, which lasts six months after you leave school.
With unsubsidized loans, you can choose to pay accrued interest while you are still in school. Otherwise, accrued interest is capitalized or added to the principal amount after graduation.
If you request and get forbearance – basically, a pause in your loan repayments, usually for about 12 months – keep in mind that while your payments may stop while you’re in forbearance, interest will continue. to accumulate during this period. and will eventually be added to your principal amount. If you are in economic hardship (which includes unemployment) and enter the deferment period, interest continues to accrue only if you have an unsubsidized or PLUS loan from the government.
Interest on student loans from federal agencies and under the Federal Family Education Loans (FFEL) program was initially suspended until September 30, 2021, by an executive order signed by President Biden on the first day of his mandate. The last extension of the suspension deadline is now January 31, 2022. Borrowers should note that although this is the fifth time the deadline has been extended, the Ministry of Education has specifically indicated that this will be the last extension.
Simple or compound interest
The calculation above shows how to determine interest payments based on what is called a simple daily interest formula; this is how the US Department of Education does federal student loans. With this method, you only pay interest as a percentage of the principal balance.
However, some private loans use compound interest, which means the daily interest is not multiplied by the principal amount at the start of the billing cycle, it is multiplied by the principal outstanding. more any accrued unpaid interest.
So on Day 2 of the billing cycle, you don’t apply the daily interest rate (0.000137, in our case) to the $10,000 of principal you started the month with. You multiply the daily rate by the principal and the amount of interest accrued the day before: $1.37. This works well for banks because, as you can imagine, they earn more interest when they compound it this way.
The calculator above also assumes fixed interest over the term of the loan, which you would have with a federal loan. However, some private loans come with variable rates, which can go up or down depending on market conditions. To determine your monthly interest payment for a given month, you should use the current rate charged to you on the loan.
Some private loans use compound interest, which means the daily interest rate is multiplied by the original principal amount for the month. more any unpaid interest charges that have accrued.
About depreciation
If you have a fixed rate loan, whether through the Federal Direct Lending Program or a private lender, you may notice that your total payment remains unchanged, even though the outstanding principal, and therefore interest charges, move from one month to the next.
This is because these lenders amortize or spread the payments evenly over the repayment period. As the interest portion of the bill continues to fall, the amount of principal you repay each month increases by a corresponding amount. Therefore, the overall bill remains the same.
The government offers a number of income-based repayment options that are designed to reduce payment amounts at the outset and gradually increase them as your salary increases. At first, you may find that you are not paying enough on your loan to cover the amount of interest accrued during the month. This is called “negative damping”.
With some plans, the government will pay all, or at least some, of the accrued interest that is not covered. However, with the Income Contingent Repayment (ICR) plan, unpaid interest is added to the principal amount each year (although it ceases to be capitalized when your loan balance is 10% greater than your loan amount). original loan).
Student Loan Interest FAQs
Who sets federal student loan rates?
Interest rates on federal student loans are set by federal law, not by the US Department of Education.
Should I consolidate for a better rate?
It depends. Loan consolidation can make your life easier, but you need to do it carefully to avoid losing the benefits you might currently enjoy under the loans you take out. The first step is to find out if you are eligible for consolidation. You must be enrolled at a lesser part-time status or not be in school; currently making loan payments or being in the loan grace period; not be in default; and raising at least $5,000 to $7,500 in loans.
Can I deduct student loan interest?
Yes. People who meet certain criteria based on filing status, income level and amount of interest paid can deduct up to $2,500.
Conclusion
Figuring out how much you owe in interest on your student loan is a straightforward process, at least if you have a standard repayment plan and a fixed interest rate. If you want to reduce your total interest payments over the life of the loan, you can always check with your loan officer to see how different repayment plans will affect your costs.
