Janice Lozano
Understanding how interest accrues on your student loans is crucial for effective financial planning. Interest rates directly impact the total amount you'll repay over the life of your loan, so knowing how and when interest accrues will help you make informed decisions about loan types, repayment strategies, and whether to make payments while still in school. Federal and private student loans have different interest accrual processes, and it's important to read and understand the terms of your loan agreement to make the best financial decisions. This paragraph aims to introduce the topic of paying accrued interest on student loans and highlights the importance of understanding interest accrual for financial planning.
| Characteristics | Values |
|---|---|
| Interest accrual start date | Interest accrues on federal unsubsidized loans and private loans as soon as they are disbursed. |
| Interest accrual calculation | Interest accrues on the original principal amount borrowed. |
| Interest accrual during grace period | Interest accrues during the grace period, and this interest is simple interest (not compounded). |
| Interest capitalization | At the end of the grace period, accrued interest is capitalized (added to the principal), and interest accrues daily on this new amount. |
| Prepayment | Prepaying accrued interest before capitalization can lower the total loan cost. |
| Payment options | Payment can be made through auto-debit, online, phone, mail, or third-party bill-pay services. |
| Repayment plans | Income-driven plans may lower monthly payments but lead to more interest accrual over time. Standard plans have higher monthly payments but less overall interest. Graduated plans start with lower payments and increase over time. |
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What You'll Learn
Interest accrual during grace periods
A grace period on a student loan is a set number of months before your first loan payment is due after you leave school. The grace period for student loans varies by loan type. For federal loans, the grace period is typically six months, and private student loan grace periods can vary by individual lender. During this period, you are not required to make monthly payments, but interest on your federal unsubsidized and private student loans will continue to accumulate.
For federal subsidized student loans, the U.S. Department of Education covers the interest on your loans until the first payment is due. This means you will not pay any interest on your subsidized loans until after your grace period ends. However, for federal unsubsidized student loans, interest starts accruing immediately when you take out the loan. Borrowers must pay all the loan interest, including interest that accumulates during periods of deferment and grace periods. You are not required to make interest payments on federal unsubsidized loans until the grace period ends, but any unpaid interest charges are capitalized, or added to your total loan amount.
Interest accrual during the grace period can be avoided by making interest-only payments while still in school or before the grace period ends. This can save a significant amount of money over the life of the loan. While prepayment does not affect your monthly payment amount, it will affect the number of times you will need to make monthly payments.
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Prepayment options
When you make a prepayment, it is important to specify that you want it applied to reduce the principal balance of the loan. Otherwise, the lender may treat it as an early payment of your next instalment and delay the next due date. This is especially important during periods of deferment or forbearance when interest is accruing but not yet capitalized.
You can use prepayment calculators to determine the impact of different prepayment strategies on your loans, including the reduction in the loan term and the total interest saved. When you have multiple loans, it is generally advisable to apply prepayments to the most expensive loans first, such as those with the highest interest rates.
While prepayment can save you money, it is important to note that it will not reduce your monthly payment amount. Instead, it will reduce the number of monthly payments you need to make. For example, if you prepaid for three months at the beginning of a 10-year repayment plan, you would still make monthly payments but for 117 months instead of 120.
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Capitalized interest
For student loans, interest begins to accrue from the day the loan is disbursed. While in school and during the grace period, the interest that accrues is simple interest, meaning it is only charged on the original principal amount. However, once the grace period ends and repayment begins, all the accrued interest is capitalized. At this point, interest will accrue daily on the new, higher principal amount for the duration of the repayment period.
To reduce the total cost of the loan, it is advisable to pay off the interest before it is capitalized. This can be done by making interest-only payments while still in school or paying off the interest just before entering the repayment phase. By doing so, borrowers can avoid paying interest on the previously accrued interest, potentially saving money over the course of the loan.
Additionally, making prepayments on the loan can also help lower the total loan cost. Prepaying the loan reduces the principal amount, which in turn decreases the interest that accrues over time. However, it is important to note that prepayments do not affect the monthly payment amount but rather the number of monthly payments required.
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Federal loan repayment plans
Yes, you can pay your accrued interest on student loans. Interest accrues (grows) from the day your loan is disbursed, and you can lower your total loan cost if you pay your interest before the capitalization period. Capitalization occurs at certain points in time, such as when your separation or grace period ends, or at the end of forbearance or deferment. At these points, your unpaid interest is added to your loan's current principal, and interest is then calculated on this new amount.
The standard repayment plan involves making equal monthly payments for ten years. This option is generally the best one to stick with to pay less in interest over time and pay off your loans faster.
The graduated repayment plan initially lowers your monthly payments, potentially to as little as the interest accruing on your loan, and then increases them every two years to finish repayment in ten years. This option may be suitable if your income is high compared to your debt, as it could free up money in the short term for a different goal, such as a down payment on a home.
The extended repayment plan starts with low payment amounts and then increases them every two years for a total of 25 years.
The income-driven repayment (IDR) plan ties the amount you pay to a portion of your income, with monthly payments set between 10% and 20% of your discretionary income. Payments can be as low as $0 if you're unemployed or underemployed, and they can change annually. IDR plans extend your loan term to 20 or 25 years, and at the end of the term, you get IDR student loan forgiveness on your remaining debt. This option is best if you're having difficulty meeting your monthly payments and need a more manageable option.
You can apply for an income-driven repayment plan with your federal student loan servicer or at studentaid.gov.
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Interest-only payments
Here's how it works: interest-only payments allow you to pay off the interest that has accrued on your loan, without reducing the principal amount. This can be beneficial while you are still in school or during a grace period, as it can lower the total loan cost in the long run. For example, if you have a $10,000 undergraduate private student loan with a 10-year repayment period and a 5.99% interest rate, your interest-only payments during school and the grace period may be approximately $50 per month. After graduation and the grace period, your full monthly payment (principal and interest) would be $110.99, resulting in a total interest repayment of $5,725. In comparison, choosing a deferred repayment option for the same loan would result in a total interest repayment of $6,524, a difference of $799.
It's important to note that subsidized student loans do not accrue interest while you are enrolled at least half-time or on an approved deferment. During these periods, making extra payments directly towards your principal balance can help minimize the overall amount repaid. Additionally, there is no federal student loan repayment plan that allows you to pay just the interest.
While interest-only payments can be a useful strategy, it is essential to carefully consider your unique financial situation and choose the repayment plan that best suits your needs. Making larger payments or paying off the loan in full earlier can also save you money on interest and shorten your repayment period. However, it is worth noting that for most students, paying off the interest as it accrues may not be financially feasible.
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Frequently asked questions
Yes, you can elect to make interest-only payments while you are still in school.
You can pay accrued interest through auto-debit, online, by phone, mail, or third-party bill-pay services.
You can lower your total loan cost if you pay your interest before the capitalization period.
You can use a calculator to help you figure out how your interest will accrue and the difference it can make if you pay your interest down.
The more principal you pay, the less interest will accrue, saving you money and shortening your repayment time.
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