Lana Oconnell
Student loan interest accrues daily, and borrowers can expect to pay more than they originally borrowed. Interest rates can be either fixed or variable. Variable interest rates may seem appealing at first, but they can increase over time, causing the loan to become more expensive. Paying off student loans early can help you graduate with less debt and put you in a better position to repay your loan. So, does interest go down the more you pay off your student loans?
| Characteristics | Values |
|---|---|
| Interest accrual | Interest accrues daily, starting the day the loan is disbursed |
| Interest calculation | Based on the principal amount |
| Interest rate | Fixed or variable |
| Variable interest rate | May increase or decrease due to changes in the loan's index |
| Fixed interest rate | Stays the same for the life of the loan |
| Deferment | Interest will continue to accrue during the deferment period |
| Interest capitalization | Occurs when unpaid interest is added to the loan's principal balance |
| Impact of extra payments | Can lower total loan cost and save money on interest |
| Income-driven repayment plans | Monthly payment may not decrease with loan payoff |
| Standard repayment plans | Paying off a loan will decrease the total monthly payment |
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What You'll Learn
Extra payments save money on interest
Student loan interest begins to accrue after the loans are issued, and borrowers can expect to pay more than they originally borrowed. Interest accrues daily, in most cases, starting the day the loans are disbursed.
Extra payments can get you out of debt faster and save you money on interest—if you can afford them. To get the full benefit, tell your servicer to apply extra payments to your highest-interest-rate loans first.
You can also reduce your interest rate by 0.25% by signing up for automatic debit. If you sign up for automatic debit, your student loan servicer will automatically deduct your student loan payment from your bank account each month. Not only does this help ensure that you make payments on time, but you may also be able to get an interest rate deduction for enrolling.
Additionally, you can pay off your loan faster by dedicating your tax refund to paying off some of your student loan debt. You may have received a tax deduction for paying student loan interest, so using that refund to pay off your loan can be an efficient way to save money.
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Interest accrues daily
Interest accrual on student loans is known as "simple interest". This means that interest is only calculated on the principal balance, not on previously accrued interest. This is different from "compound interest", which is the type of interest that accrues on most major credit cards. With compound interest, you are paying interest on interest, which can increase the total cost of the loan.
For federal student loans, interest will be capitalized (added to the principal balance) under certain circumstances. For example, if you exit a period of deferment on an unsubsidized loan or if you are repaying a loan under an income-based repayment (IBR) plan and your financial situation improves. Capitalization increases the total cost of your loan, so it is beneficial to make payments during any period when they are not due to avoid capitalization.
It is important to note that extra payments on student loans can help you get out of debt faster and save money on interest. If you can afford it, it is recommended to make extra payments and apply them to your highest-interest rate loans first. Additionally, staying in touch with your loan servicer and keeping good records can help you stay on top of your payments and avoid any problems.
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Variable interest rates can increase over time
Variable interest rates on student loans can increase over time. This is because they change with the financial markets. While variable rates may seem appealing at first, they can end up costing significantly more over the life of the loan. Interest accrues daily, in most cases starting the day the loan is disbursed. This means that the longer you have the loan, the more interest you will pay.
There are two primary types of interest rates: fixed and variable. A fixed interest rate stays the same for the life of the loan, whereas a variable interest rate may fluctuate due to changes in the loan's index. For variable rate Sallie Mae loans applied for on or after April 1, 2021, the Secured Overnight Financing Rate (SOFR) is used as the index. Prior to this date, the London Interbank Offered Rate (LIBOR) was used.
It's important to note that interest is calculated as a percentage of the current principal. Therefore, the lower the principal, the less interest you will pay each month. Making extra payments can help reduce the total interest paid over time. Additionally, paying off the loan with the highest interest rate first can be a good strategy to minimize the total interest paid.
To avoid paying unnecessary interest, it is recommended to start repayment early, even while still in college. This can help to reduce the total loan amount by the time of graduation. Additionally, staying in touch with the loan servicer and keeping good records can help identify any issues early on.
In summary, variable interest rates on student loans can increase over time due to changes in the financial markets. To minimize the impact of rising interest rates, it is advisable to reduce the principal as quickly as possible, make extra payments when possible, and consider the loan's index when choosing between fixed and variable interest rates.
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Federal loans may have interest capitalized after deferment
Interest capitalization can occur under a few different circumstances. Firstly, if you have an unsubsidized federal loan, interest will accrue during the deferment period. This includes Grad PLUS and Unsubsidized Loans, where interest starts immediately after disbursement. If you do not pay the accrued interest during the deferment, it will be capitalized and added to your loan principal balance when you have to start making payments.
Additionally, interest capitalization can occur if you are repaying your federal loans under an income-based repayment (IBR) plan. If you no longer qualify for financial assistance or need to make payments based on your income, the interest may be capitalized and added to your principal balance.
To avoid or minimize interest capitalization, it is advisable to make small additional payments or pay off some or all of your accrued interest before the deferment period ends. This can help keep your total loan cost down. There are various repayment options available for federal loans, including income-based repayment plans, which can provide flexibility based on your income.
It is important to understand the difference between fixed and variable interest rates. A fixed interest rate remains the same throughout the loan period, while a variable interest rate may fluctuate depending on the loan's index. Variable interest rates can increase or decrease the total cost of your loan over time.
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Paying off individual loans can decrease monthly payments
Paying off individual loans can help decrease monthly payments. This is because interest accrues daily, with interest being a percentage of the current principal. Therefore, as the principal decreases, the interest owed decreases too.
For example, if you have a 30-year fixed-rate mortgage of $200,000 with an interest rate of 4%, your monthly mortgage principal and interest payment will be $955 for the life of the loan, totalling $343,739, of which $143,739 is interest. However, if you pay $100 extra each month towards the principal, you can cut your loan term by more than 4.5 years and reduce the interest paid by more than $26,500. This is because, at the beginning of the loan term, most of the monthly payment covers the interest, with a smaller amount going towards the principal balance. As you pay down the principal, you owe less interest each month, and more of your monthly payment goes towards paying off the principal. This process is known as amortization.
Additionally, for federal student loans, interest will be capitalized – or added to your principal – under two circumstances: when you exit a period of deferment on an unsubsidized loan or when you are repaying a loan under the income-based repayment (IBR) plan and you no longer need financial assistance. Therefore, by paying off individual loans, you can avoid capitalization and decrease your monthly payments.
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Frequently asked questions
Yes, the lower your principal balance, the less interest you’ll have to pay each month. So, the more you pay off your student loans, the lower your interest will be.
Here are some ways to pay less interest on your student loans:
- Make your payments on time
- Pay a little extra with each payment
- Avoid extending your repayment term
- Avoid deferring your interest payments
- Claim your student loan interest on your tax return
Interest is the fee you pay the lender for borrowing their money. Interest accrues daily, starting on the day your loans are disbursed. Your interest rate is the percentage of your loan amount (called your “principal”) that you'll be charged for each year that you hold the loan.
