Loans aren’t free. When you borrow money, you will not just pay back the amount you borrowed; lenders will charge you interest.
The simplest way to think of it is interest is the cost you pay to borrow money. Whether you have federal student loans or private student loans you will be charged interest until that loan is repaid in full. That means, when you are done paying off the loan, you will have repaid the original amount you borrowed (known as your original principal), plus a percentage on the amount you owe (interest).
Interest can be handled in a few different ways, depending on the type of loan you have.
Currently, federal student loans have a fixed interest rate—meaning the interest rate stays the same for the entire life of the loan—and they apply that rate using the simple daily interest formula.
Private loans can have either a variable interest rate (meaning it may change based on the overall economy/market) or a fixed interest rate (meaning it will stay the same over the life of the loan). In addition, the interest can be applied to your loan with the simple interest formula or a compounding interest formula.
NOTE: If you have a private loan, or are researching private loans, you will encounter a wide range of interest rates. This is why it’s important to research more than one lender to determine the interest rates and repayment terms of each private loan. Also note that lenders typically impose a cap—or ceiling—on variable interest rates which provides an assurance that your rate will not exceed the established, maximum rate. But this will vary by lender.
Regardless of whether you take out a federal student loan or a private student loan, and whether your interest is accrued (adding up) with the simple daily interest formula or the compound interest formula, you will be charged interest every day.
If you have a subsidized loan, there are certain periods of time, like when you are in-school at least half-time or during a grace period, when the Department of Education pays the interest. When you are not in one of those approved periods, your interest will accrue daily. If you have an unsubsidized loan, your interest will accrue daily, even when you are in school and during a grace period.
Whether you have a subsidized or unsubsidized loan, the simple daily interest formula will be used to calculate how much interest you will be charged.
Your loan servicer will keep track of your total interest as it adds up. There are certain times when the lender can add the accumulated interest to your principal balance in a process known as capitalization. This will increase the total amount of your principal balance, and any future interest charges will be based off of this new amount.
Capitalization is important to understand. Your lender will capitalize any time your loan changes its loan status—like going from in-school deferment into repayment. For example, if you weren’t making payments on your unsubsidized loans while enrolled in school, interest was accumulating. Once you enter repayment that accumulated interest is added to your principal. This new balance will become the outstanding principal balance of your loan.
There are some “best practices” to consider when you enter repayment and have the ability to choose your repayment plan. If you can afford it, it’s best to choose a plan that will cover more than your monthly interest charges. There are repayment plans that base your monthly payments on your income, but that may not be enough to start seeing a decrease in how much you owe. Although some of those income-driven plans will have an interest subsidy for a certain period of time, it may make you feel like your payments aren’t bringing down your loan balance. This is because payments are applied to the interest you owe first and the principal balance second.
Interest can create a significant cost to your loan. Here’s an example of the simple interest formula:
Say you have an unsubsidized loan balance of $5,500 that you borrowed with a fixed interest rate of 5%, and you want to know how much it is costing you, per day, to borrow this money.
You would multiply $5,500 by .05 (5%) and divide by 365. The total of this calculation, is your daily cost.
$5,500 X 0.05/365 = 0.753
If you do not make payment to bring down your principal loan balance (and assuming you have not had any interest capitalized), this is the cost of your loan over time.
The 30-day cost of this loan is $22.60.
The 90-day cost of this loan is $67.81.
The 180-day cost of this loan is $135.62.
The annual 365-day cost of this loan is $275.
The 1,460-day (4-year) cost of this loan is $1,100.
The 2,005-day (approx. 4 years and 6 months) cost of this loan is $1,509.**
**This is not an uncommon scenario for a loan someone borrowed their freshman year of college.
Since private loans come from private lenders, each private loan will have its own terms and conditions. While a private lender may use the simple daily interest formula, they will most likely use a compound interest formula to determine the daily cost of your loan.
A compound interest formula calculates the cost of your loan by applying your interest rate to your principal (the original amount you borrowed) as well as any interest that has built-up on your loan. In other words, the cost of your loan will be assessed on not only the original amount you borrowed, but any outstanding interest as well.
In order to get more information about the effect of interest on your loan, you should contact your lender (or the lender you hope to work with). Many lenders even offer repayment calculators to help you understand the cost of a loan.
If you are looking to finance your college education, you should understand what type of earning potential you will have once you graduate. Everyone has different dreams, goals, and earning potential. Some people want to make six-figure-plus incomes, while others have a dream job that typically comes with a more modest salary. These two types of individuals should not be considering the same amount of loan debt.
Loans cost money, and there is a reason why there is such an emphasis of borrowing within your means. Understand the financial commitments you are making, and how interest accrual impacts the overall amount you will need to repay.
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