Lori Meadows
Student loan interest is the cost of borrowing money from a financial institution, and it increases the total amount paid back. Interest accrues daily, starting from the day the loan is disbursed, and can be calculated using a simple interest formula. Interest rates can be fixed or variable, with federal student loans having fixed interest rates that stay the same throughout the loan period. Private student loan interest rates vary by lender and can increase or decrease based on market conditions. Unpaid interest may be capitalized, meaning it is added to the loan's principal balance, resulting in interest being charged on the new, higher amount. This can lead to negative amortization, where the total amount owed increases despite making regular payments. To avoid this, borrowers can explore strategies such as securing lower interest rates, refinancing, or making additional payments to reduce the principal balance. Understanding the impact of interest and utilizing tools like student loan calculators can help borrowers manage their debt effectively.
| Characteristics | Values |
|---|---|
| Interest accrual start date | The day your loan is disbursed |
| Interest accrual frequency | Daily or monthly, as stated in the promissory note |
| Interest capitalization | Occurs when unpaid interest is added to the loan's current principal |
| Interest capitalization timing | End of separation or grace period, end of graduate school deferment, or when the loan enters repayment |
| Loan repayment start date | One year after the loan is fully disbursed |
| Repayment plan options | Standard repayment plan, income-driven repayment (IDR), Saving on a Valuable Education (SAVE) plan, income-based repayment (IBR), income-contingent repayment |
| Interest rate types | Fixed, Variable |
| Loan fees | Late payment fees, disbursement fees |
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What You'll Learn
Understanding interest and capitalization
Interest accrues daily, in most cases, starting from the day your loan is disbursed. This means that your loan balance will increase even if you're making regular payments, as the monthly payments may not be enough to cover the accrued interest. This is called negative amortization.
Interest rates can be either fixed or variable. A fixed interest rate stays the same for the life of the loan, whereas a variable interest rate may fluctuate.
Capitalized interest is the unpaid interest that gets added to your loan's current principal. This increases the total amount you have to pay back. Capitalization of interest occurs at certain points in time, such as when your grace period ends, or at the end of a period of deferment or forbearance. Depending on the type of loan, unpaid interest may be capitalized after a period of deferment or forbearance, meaning that it will be added to your loan principal balance when you resume making payments.
You can avoid or lower the amount of capitalized interest by paying off some or all of your accrued interest before your grace period ends.
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How to lower your total loan cost
The total cost of a student loan depends on various terms such as monthly payment, repayment period, and interest rate. Here are some strategies to lower your total student loan cost:
- Make payments while in school: If your student loan starts to collect interest right away, making payments while in school, even small ones, can help reduce the total loan cost.
- Focus on high-interest loans: Identify the loans with higher interest rates and focus on paying those first. By strategically making extra payments toward these loans, you can save on accrued interest and reduce your repayment timeline.
- Increase payment frequency: Instead of making one monthly payment, switch to bi-weekly or half-monthly payments. By doing so, you will make an extra month's payment each year, reducing your principal balance faster and lowering your total interest costs.
- Enroll in an income-driven repayment plan: The federal government offers income-driven repayment plans that adjust your monthly payments according to your income and family size. This can make your payments more manageable and may even lead to loan forgiveness after a certain period.
- Take advantage of loan forgiveness programs: If you work for the federal government or a qualifying non-profit organization, you may be eligible for public service loan forgiveness. Additionally, borrowers who teach full-time in certain eligible institutions may qualify for teacher loan forgiveness.
- Refinance your student loans: Refinancing involves taking out a new loan with a lower interest rate or a longer repayment term, which can significantly reduce your monthly payments. However, refinancing federal student loans will convert them to private loans, resulting in the loss of federal benefits such as loan forgiveness and income-driven repayment plans.
- Make lump-sum payments: When you receive extra money, such as tax refunds or bonuses, consider using a portion of it to make a lump-sum payment toward your student loans. This can help reduce your total loan cost by lowering the principal balance and the interest accrued over time.
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How interest accrues
Interest on student loans accrues daily, usually starting from the day the loan is disbursed. The interest rate on a student loan is a percentage of the amount borrowed that must be paid back in addition to the principal amount. The interest rate is calculated based on various factors, including market conditions, the type of loan (federal or private), loan term, income, credit history, and the income and credit history of a potential cosigner.
The interest accrues even during the deferment and grace periods, so borrowers will owe more than they initially borrowed when they enter repayment. For example, if someone borrows $20,000 in student loans and $2,000 in interest accrues based on the interest rate during their time in school, their total outstanding loan balance will be $22,000 when they start repayment. The monthly student loan interest will then be calculated on this new, higher balance.
Borrowers with subsidized federal loans are exempt from paying interest while their loans are in a deferred status, such as during their time in school or the post-school grace period. The government also pays the interest during periods of deferment due to circumstances like economic hardship, unemployment, or military deployment. However, borrowers with unsubsidized federal loans are responsible for the interest that accrues during deferment or forbearance, and it may be capitalized and added to their loan principal balance when they resume payments.
Negative amortization can occur when the total amount owed increases as the borrower repays the loan because they are not paying off the interest each month. This can happen with income-driven repayment plans, where the monthly payments may not be sufficient to cover the accruing interest, causing the remainder to stack up and increase the loan balance.
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How interest capitalizes
Interest on student loans accrues daily, in most cases, starting the day the loans are disbursed. If you have a subsidized federal loan, the government will pay your interest while your loans are in a deferred status, for example, if you are still enrolled in school. Unpaid interest may be capitalized after a period of deferment or forbearance, meaning that it will be added to your loan principal balance when you resume making payments. This is known as negative amortization, where the total amount you owe increases as you repay your loan. This can occur if you are in deferment for an unsubsidized loan or if you have an income-based repayment (IBR) plan and your payments are not large enough to cover the accruing interest.
For federal student loans, capitalization of unpaid interest occurs at the end of the deferment period, when any unpaid interest will be added to the loan's current principal. This can increase the total amount you have to pay back. You can avoid this by paying off the interest before it capitalizes. For example, if you’ve chosen the interest repayment option for your student loans, your interest shouldn’t capitalize, since you’ve paid it as it has accrued throughout school.
If you are on the Income-Contingent Repayment (ICR) plan, interest capitalizes annually. For private student loans, interest capitalization typically happens when you consolidate federal loans, but check with your lender to confirm.
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Federal vs private student loans
Federal student loans are offered by the government and have low eligibility requirements, making them accessible to most borrowers. They offer valuable borrower protections, such as income-driven repayment plans and loan forgiveness programs. Federal loans always have fixed interest rates, and all borrowers get the same rate regardless of their credit score. To apply for federal student loans, individuals need to complete the Free Application for Federal Student Aid (FAFSA).
Private student loans, on the other hand, are provided by banks, credit unions, and other financial institutions. They typically lack the borrower protections that come with federal loans and often require borrowers to qualify based on their creditworthiness. Private loans usually offer a choice between fixed or variable interest rates. Fixed rates provide predictable monthly payments, while variable rates can change over time, making monthly payments unpredictable. Private loans offer different repayment plans, including options to make interest-only or fixed payments while in school, potentially lowering the total loan cost.
Graduate students can borrow up to $138,500 in direct federal loans, while private loan borrowing limits vary by lender, generally allowing borrowers to borrow up to the school's cost of attendance. Federal loans have origination fees, which are low for undergraduate students but can be high for graduate students, professional students, and parents.
It is generally recommended to consider federal loans first due to their favourable terms and conditions, and then turn to private loans if there are remaining costs. Federal loans are currently the most popular choice, with roughly 92% of outstanding student loans being federal.
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Frequently asked questions
Interest on student loans accrues daily, starting from the day the loan is disbursed. The interest rate is what you pay to borrow money, depicted as a percentage. There are two types of interest rates: fixed and variable. A fixed interest rate stays the same for the life of the loan, while a variable interest rate may change over time based on debt market conditions.
Interest capitalization occurs when unpaid interest is added to the loan's current principal. This happens at certain points, such as the end of a grace period or deferment period. Interest will then accrue based on the new, higher amount.
You can lower your total loan cost by paying your interest before the capitalization period. If you've chosen the interest repayment option, your interest won't capitalize since you've paid it as it accrued. Making small additional payments or paying off accrued interest before the grace period ends can also help lower the amount of capitalized interest.
