How Does Student Loan Interest Work?
Posted by Frank Gogol in Loans | Updated on May 30, 2023
If you are seeking ways to pay for your education, there are several options to explore. Getting a student loan is a common choice. There are a lot of different options you can explore including various types of federal and private student loans. One of the major decision points is how much it will cost. Interest is the largest proportion of the cost of a loan so it is important to understand how student loan interest works. Read on to learn more.
Table of Contents
What Is Student Loan Interest?
Student loans, just like other types of loans, accrue interest. Interest is the cost of a loan, the extra amount you have to pay back to the lender on top of the actual amount you borrowed. This original amount is called the principal, and it is used along with the interest rate to calculate how much interest you will have to pay.
How Does Interest on Student Loans Work?
The legal agreement between you and the lender is called a promissory note. A promissory note sets the details of your loan.
These details include:
- Principal: The amount you are borrowing. This is the sum of money that will actually be sent to your account.
- Disbursement date: The date on which the lender will pay out the principal to you.
- Interest rate: Determines how much interest you will be charged for the loan and what type (i.e. fixed or variable).
- Interest accrual: The amount of interest you end up paying also depends on how it accrues (e.g. daily or monthly).
- Interest capitalization: Interest capitalization is when the interest due on your loan is added to the principal and then interest is recalculated based on the new, higher principal. How often and under what circumstances this happens can greatly affect your loan.
- Fees: The lender can also charge extra fees such as origination fees, late fees, and early-payment fees.
- Date of first payment: Different lenders have different requirements for when you need to start repaying the loan. Some only require you to begin paying once you are employed, others after graduation, and a few require payment while you are still studying.
- Payment schedule: It is very important to make sure that the repayment schedule (amounts and frequency) will work for you. If you fail to make payments on time, it could damage your credit score.
It is important to read and understand the entire promissory note before you sign it. Make sure you understand everything that will be required of you, and everything you can expect from your lender.
Unsubsidized Student Loans vs. Subsidized Student Loans
This section outlines how subsidized and unsubsidized student loans differ in how interest accrues.
Unsubsidized Loans
Unsubsidized student loans begin accruing interest as soon as the lender gives you the loan principal. The date of interest accrual is not the same as the date of the first payment.
If the date of the first payment is after the date of interest accrual, it means you will not have to make payments, but the amount you owe will increase continually.
Subsidized Loans
Subsidized federal student loans do not accrue interest while you are studying. There is also a 6-month grace period after you graduate (or stop attending full-time) during which interest still won’t be charged. The amount you owe will be the same on the date of the first payment as it was on the disbursement date.
How Is Student Loan Interest Calculated?
The details of how student loan interest works depend, in part, on the type of interest being charged – fixed or variable.
Fixed Interest
A fixed-interest loan charges the same percentage of the principal per month. In practice, this means your repayments will be the same over the life of the loan.
Variable Interest
The percentage interest of a variable rate loan changes over time. Therefore, your monthly payment could change quite a lot over time. This is the riskier alternative, even if it may seem more affordable at first.
When Does Student Loan Interest Begin?
One key to understanding how student loan interest works is knowing when the interest charges begin.
The list below outlines the usual interest accrual dates for a few types of loans:
- Subsidized federal student loans: The subsidy is payments from the federal government for accrued interest on your loan. Your loan only begins accruing interest at the end of a 6-month grace period after you stop studying full time.
- Unsubsidized federal student loans: Without the subsidy, interest will accrue from the disbursement date. However, you won’t have to make the first payment until after you graduate.
- Federal Direct PLUS: All federal PLUS loans (for parents and graduates) accrue interest from the disbursement date.
- Private student loans: Private loans begin accruing interest as soon as the principal is disbursed.
How Interest Accrues on Student Loans and Parent Loans
The frequency with which interest on your loan balance is calculated affects how much interest you will ultimately be charged. Federal student loans and Direct PLUS parent loans accrue interest daily.
The interest accrual period for private student loans varies between lenders.
Student Loan Interest FAQ
The following questions often come up when discussing how student loan interest works.
What happens if you don’t make full payments each month?
Any partial payment is counted as a missed payment by the lender and will be treated as such when reporting to credit bureaus.
If you realize you will not be able to handle the current payment schedule, contact your lender immediately to arrange a new schedule.
How are extra student loan payments treated?
If you have the financial ability to make extra payments, it is usually recommended that you do so. This is because the more you reduce the outstanding balance, the less compound interest will be charged on it later in the life of the loan.
A relatively small extra payment upfront can save you a lot of money in avoided interest. Keep in mind that some lenders charge early termination fees, so if you finish paying the loan off completely early you may be subject to substantial extra fees.
If you decide to make extra payments and want them treated differently than what is set out in the promissory note, instruct your lender in writing.
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Final Thoughts
When figuring out how student loan interest works, one of the most important factors is when the interest starts accruing. It also makes a difference how often the accrued interest is calculated, either daily or monthly. When it comes to federal student loans, there is the option of having the federal government subsidize your loan so that the interest accrued while you are studying is paid off. All of the details of a loan are set out in a document called the promissory note.
