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How Does Interest on Student Loans Work?

What Is Student Loan Interest?

Loans aren’t free. When you borrow money, you will not just pay back the amount you borrowed; lenders will also 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 paid 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).

In today’s marketplace, private student loan interest rates range from around 0.99% APR (annual percentage rate) up to 14.50% APR. Many private student loan lenders offer both fixed and variable interest rates, enabling eligible borrowers to choose the option they prefer. The interest rate you qualify for will be based on your creditworthiness you and that of your cosigner, if applicable. You can easily compare lender rates, terms, and benefits on our student loan lender comparison page.

Instantly Compare Private Student Loan Lenders

Interest is generally assessed by using a simple daily formula or a compounding interest formula. It’s important to understand the difference between these two formulas so you understand how your interest is calculated.

How Simple Interest Works

When you have a simple interest loan, also known as the simple daily interest formula, interest is calculated based on your outstanding principal balance. All federal student loans charge interest using this formula. Some private student loans will also use the simple daily interest formula, and you can confirm this in the terms and conditions of your loan.

How Compound Interest Works

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 outstanding or unpaid interest that has been adding 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. You may have heard people refer to this as being charged “interest on interest.” This may be a method a private student loan may use to calculate your interest charges.

Fixed vs Variable Interest Rates

Another common source of confusion is the difference between fixed and variable interest rates. Both types of interest rates may be offered by private student loan lenders, so it’s important to understand the difference.

What Is a Fixed Interest Rate?

A fixed interest rate is a rate that stays the same for the life of the loan. If you borrow a loan at 5% interest, your interest rate will not change over the life of your loan. It will remain at 5%.

Federal student loans all have fixed interest rates. Private student loans will generally give you an option to choose a fixed or variable rate.

Pros and Cons of Fixed Interest Rates

Pros Cons
Lower-risk — monthly payments are stable Rates are typically higher than variable rates
While a variable rate can increase, a fixed rate cannot While a variable rate can decrease, a fixed rate cannot
If you have a strong credit history, you can qualify for a lower fixed rate The lowest advertised fixed rate may not be available if your credit is not strong enough

What Is a Variable Interest Rate?

Typically, a private student loan lender’s lowest advertised rate is a variable interest rate. A variable interest rate may change throughout the life of the loan, yielding a different loan payment every time the interest rate changes. The interest rate when the loan enters repayment may be much different than the interest rate when you first obtained the loan.

Also, variable interest rates are often expressed as the sum of a variable rate index and a fixed margin. The variable rate index is a reference rate that changes periodically, such as the LIBOR index, SOFR (Secured Overnight Financing Rate), the Prime Lending Rate or the interest rates on U.S. Treasuries.

For example, the lender might specify the interest rate as Prime + 5%. Some may misinterpret this as a 5% fixed interest rate, ignoring the variable-rate index part of the equation. If the Prime Lending Rate is 3.25%, then Prime + 5% yields an 8.25% interest rate. If the Prime Lending Rate were to increase to 6%, then Prime + 5% would yield an 11% interest rate. Variable interest rates typically change monthly, quarterly or annually.

It's important to note that when your interest rate changes your payments will go up or down accordingly. It’s important to be prepared for your payments to potentially increase should your interest rate rise. We always recommend that you estimate your monthly payments based on the low-end of your interest rate range, and the high-end. Both of these payments should be considered affordable to you. You can use our Loan Payment Calculator.

Pros and Cons of Variable Interest Rates

Pros Cons
Rates are typically lower than fixed rates Higher risk — monthly payments can fluctuate
If the interest rate decreases, you pay less If the interest rate increases, you have to pay more
Those with strong credit may qualify for a lower variable rate The lowest advertised variable rate may not be available if your credit is not strong enough


How Is Student Loan Interest Calculated?

Let’s go over how student loan interest is calculated, and let’s explain the cost of your loan.

As a reminder, the U.S. Department of Education (ED) offers federal student loans that can be subsidized or unsubsidized. For both types of loans, the simple daily interest formula is used to calculate how much interest you will be charged. Direct Stafford loans, which can either be subsidized or unsubsidized loans have fixed, low interest rates.

Since private student 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 may use a compound interest formula to determine the daily cost of your loan.

Simple Interest Formula

Say you have an unsubsidized student loan with an outstanding balance of $10,000 and a fixed interest of 5%. To determine your daily cost, you would multiply your outstanding principal balance by your interest rate and divide it by 365.

Multiple $10,000 by 0.05 (5%) and divide by 365.

$10,000 X 0.05/365 = 1.370

The daily cost of your loan is $1.37.

This chart shows what the accrued interest over 28 days would be on a $10,000 loan balance with a 5% interest rate.

Outstanding Principal Balance Annual Interest Rate Number of Days Interest Accrued
$10,000 5.00% 7 $9.59
$10,000 5.00% 14 $19.18
$10,000 5.00% 21 $28.77
$10,000 5.00% 28 $38.36

You can start to see how expensive your loan will get over time. Now let’s take this a step further. Let’s look at the cost of your loan over a few years.

This example is showing the cost if you have made zero payments, and interest has not been capitalized to your outstanding principal balance.

Outstanding Principal Balance Annual Interest Rate Number of Days Interest Accrued
$10,000 5.00% 365 (1 year) $500.05
730 (2 years) $1000.10
1095 (3 years) $1500.15
1460 (4 years) $2000.20

Compound Interest Formula

Remember that federal student loans use the simple daily interest formula. But you may encounter a private student loan which uses a compound interest formula; however, some will still use a simple daily interest formula. To compare the difference in how the interest is applied, take a $25,000 loan and an interest rate of 5.00%.

With simple interest, the $25,000 loan accrues $3.43 in interest per day. This is because the principal balance is not changing during this time.

On the other hand, with compound interest the $25,000 loan with the same interest rate would accrue $3.43 the first day, but then new accrued interest of $3.43 would be added to the principal balance to determine the interest for the second day. This process continues throughout the month, leading to you pay more in interest per day because the principal balance is rising every day that a payment isn’t made.

What is Capitalized Interest?

Capitalized interest is unpaid interest that gets added to your outstanding principal balance. Once the interest on a loan is capitalized, you will then have to pay interest on the interest. This is important to understand because your outstanding principal balance could increase if outstanding interest is added to it.

Student Loan Interest Capitalization

In the federal student loan program, there are specific interest capitalizing events, like the change of a repayment status (e.g., entering repayment after your grace period). When it comes to private student loans, it’s important to read the terms and conditions to understand when your lender will or can capitalize any outstanding interest onto your principal balance.

When Do Student Loans Start Accruing Interest?

Student loans, and most loans in general, begin to accrue interest as soon as they are disbursed. For student loans, the bigger question is who is paying the interest and at what time? Who pays the interest on your student loan will vary depending on the type of loan(s) you have.

Federal Subsidized Loans

Federal subsidized loans are need-based loans that are only available to undergraduate students. If you have a subsidized loan, there are certain periods of time—like when you are in-school at least half-time, during your grace period, and authorized periods of deferment—when the federal government pays the interest on the loan. Outside of those approved periods, it’s your responsibility to pay back the accrued interest.

Federal Unsubsidized Loans and Private Student Loans

Undergraduate, graduate, and professional students may be offered Direct Stafford Unsubsidized Loans. Unsubsidized loans may also come in the form of Direct PLUS Loans which can be offered to parents of dependent undergraduate students, as well as graduate or professional students (Grad PLUS Loans). And when it comes to private student loans, these can be borrowed by students and parents. Federal unsubsidized loans and private student loans do not include an interest subsidy, which means you are responsible for the interest as soon as the loan is disbursed.

How Are Student Loan Payments Applied?

When you make a payment on your student loans, your lender or servicer will apply your payment in a certain order. Your monthly payments will be applied to any outstanding interest first, and any amount left over will be applied to your principal balance. This is always the order of things.

You may have heard of techniques to pay down your debt fast, and many of them involve paying more than your minimum monthly payment in order to have those payments applied to your outstanding principal balance.

When you make an overpayment (i.e. pay more than your monthly payment amount), you will need to let your servicer know how to handle the payment. If you have multiple loans and want the extra payment to be applied to a particular loan, you will need to spell this out in your instructions. Also, if you want the extra amount to go to your principal balance without advancing your due date, say so. If you do not specify this, your servicer may just advance your payment due date automatically—basically that means that your overpayment will go towards to your next payment due.

It’s important to understand that your servicer cannot apply extra payments to reduce your principal balance if your account is past due and the payment needs to cover any outstanding interest. This can be a point of confusion. If you’re trying to pay off loan A faster, but loan B has outstanding interest, your servicer may not be able to fulfill your request to apply extra payments to your principal balance on loan A until all of the outstanding interest on loan B is satisfied.

Now how do you use this knowledge to your benefit while you’re in school? Since your student loan will likely be using a simple daily interest method to calculate your daily cost, your goal should be to pay down the interest while you’re in school to avoid a larger outstanding principal balance when you enter repayment (because of capitalization). BONUS: if you only have subsidized loans, you can make interest-free payments while you’re in school and during your grace period. This is because the government is paying the interest on your behalf. So, each payment you make will go directly to your principal balance.

Interest Rates for Federal Student Loans

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.

Federal Student Loan Interest Rate 2021-2022

The following lists current federal student loan rates for comparison. These rates are fixed for all borrowers and are valid from July 1, 2022 to June 30, 2023.

Undergraduate Subsidized or Unsubsidized Graduate Subsidized PLUS Loans
 4.99% 6.54% 7.54%

Interest Rates for Private Student Loans

Private loans can have either a variable interest rate (meaning it may fluctuate with market changes) or a fixed interest rate (meaning it will stay the same over the life of the loan).

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 that work for you. 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 accrues (keeps growing) with the simple daily interest formula or the compound interest formula, you will be charged interest every day.

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Making Payments on Student Loan Interest While In School

Paying your student loans while in school is a great tactic to save money on interest paid over the life of the loan. In fact, some private student loan lenders provide lower interest rates to borrowers who agree to repay the interest on their loans while they are enrolled in school. Choosing not to make interest payments while in school may permit your lender to capitalize your interest, or add the accrued interest to the principal balance of your loan once you enter repayment. Making interest-only payments may prevent this from happening and ensure that your loan principal balance isn’t larger than what you originally borrowed.

How to Lower My Interest Rate on Federal Student Loans

To lower your interest rate on federal student loans, you basically need to refinance them with a private lender. In the federal student loan program, you are pretty much locked in with your fixed rate. However, if you choose to enroll your monthly payments in auto-debit, you could qualify for a 0.25% interest rate reduction.

The federal student loan program does have an option to consolidate your student loans, however federal consolidation does not necessarily change your interest rate much. If you choose to combine your loans with a Direct Consolidation Loan, your interest rate will be based on the weighted average of the loans you combined, rounded up to the nearest 1/8th of a percent.

If you would like to lower your interest rate on a federal student loan, you may want to consider refinancing with a private student loan lender.

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Variable as low as: 3.44% APR1

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How to Get a Lower Interest Rate on Private Student Loans

  1. Apply with a cosigner who has a very good credit score and strong credit history
  2. Take advantage of any interest rate discounts (such as 0.25% reduction for signing up for automatic debit) offered by your lender.
  3. Consider private student loan refinancing after you start repaying your loans. If your credit or your cosigner's credit has improved, you may qualify for a lower interest rate.
Could student loan refinancing save you money?


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