How Does Student Loan Interest Work?
When taking out loans to cover the costs of college, most students aren’t looking ahead to the decades after graduation. They might know that student loan repayment is on the horizon, but borrowers often fail to consider the interest that can quickly accrue once their loan is disbursed.
How does student loan interest work, exactly? What’s involved in setting interest on student loans? What should a reasonable monthly payment look like?
These are crucial questions that all borrowers should ask to avoid taking on too much debt and to stay afloat when loan servicers start sending the bill. This guide will help you understand the basics of student loan interest, how to find good rates, and the best methods for developing a repayment plan.
How does student loan interest work?
As with a mortgage or any other type of loan, student loans are not free advances. Because of interest, the amount you borrow is typically less than what you will end up repaying over the life of the loan.
When you apply for a student loan from the U.S. Department of Education or a private financial institution, you will be quoted an interest rate. Depending on the information you provide in your application, this might or might not be your final rate.
The student loan interest rate your provider settles on is expressed as an annual percentage rate, or APR, which represents the actual yearly cost of funds over the term of a loan. Your rate could be fixed or variable.
Fixed: A fixed APR will remain the same for the extent of your loan term.
Variable: A variable APR fluctuates with changes to the market index to which it is tied. Variable interest rates are often lower than fixed rates at the outset, but might increase over the term of your loan.
You will be required to sign a promissory note before your provider disburses your loan. This note will indicate your official rate, and also outlines:
Terms and conditions of your loan(s)
Repayment plan choices
Late charges and collection costs
Explanations of defaulting, forbearance, consolidation, and any other pertinent information
Each day or month, the interest your loan generates will be tacked onto your total balance, which includes the principal (the initial borrowed amount) and interest accrued.
You must repay the interest prior to paying down the principal balance, so failing to make payments makes your debt more expensive over time.
How Often Is Student Loan Interest Compounded?
Compound interest is the addition of interest to the principal of a loan. Put simply, it is interest on the interest.
The promissory note for your student loans will also indicate how often your interest accrues as well as your compounding rate. Most student loans accrue interest daily and compound either daily or monthly.
Daily accrual means that lenders will divide the APR by 365 and apply that daily interest rate to your principal balance each day. Daily compounding would mean that your APR would also be applied to the amount of interest that accrued the day prior, in addition to the rest of your principal amount.
As such, compounded interest is constantly tacked onto your balance and incorporated into your next interest charge. So, the longer you take to address interest, the higher your compounded interest balance can climb.
See the full guide here:How Does Student Loan Interest Work?
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