Student loan interest can be complicated. It is not as simple as taking your fixed student loan interest rate and applying it to whatever your current balance is. There is a sneaky little algorithm in there that will increase your total debt little by little so it is very important to understand how student loan interest works with your debt in order to determine the best plan of attack for repayment.
WHAT IS INTEREST?
Interest is extra money paid at regular intervals at a specified rate. It is charged as the cost for borrowing money or for delaying the full repayment of debt. Economically speaking, interest ensures that people and companies, who are lucky enough to have a surplus of cash, have incentives to lend it to people with valuable projects to fund. Of course, lenders are also in the business of making money and are happy to accept interest payments.
HOW OFTEN DOES INTEREST ACCRUE?
Interest is applied and starts to grow as soon as your loan is disbursed to you or your school. It does not stop until you pay it off. Unlike some other types of loans or credit, Direct Loans from the Federal Student Aid program are also daily interest loans where interest accumulates on a daily basis not monthly.
HOW IS STUDENT LOAN INTEREST CALCULATED?
For Federal Student Loans, the math is complicated and it may seem a little sneaky if you don’t take the time to review all of the information that is provided to you when you take out a loan.
Get ready for your eyes to glaze over…but do your best to prevent that from happening…
Interest is calculated as a percentage of the unpaid principal amount. The amount of interest that accrues month to month is based on a daily interest formula. Here is what the formula looks like:
Interest Amount = (Outstanding Principal Balance × Interest Rate Factor) × Number of Days Since Last Payment
*Interest Rate Factor = Your loan’s interest rate divided by the number of days in the year.
WHAT IS CAPITALIZATION?
Capitalization happens when you do not pay student loan interest in full and any remaining unpaid interest is added to the loan’s current principal balance.
This applies to specific milestones of a loan. The first milestone is at the end of your separation or grace period. The second milestone is at the end of forbearance or deferment.
For example, even if your loan is in deferment and you do not have to make any payments, interest will continue to grow during the deferment period. At the end of this deferment period, any unpaid interest will capitalize. This mean that the unpaid interest will be added to the current principal and future interest will be calculated on this new balance. Not very nice!
PAYMENTS APPLY TO OUTSTANDING INTEREST FIRST
When you are determining if a student loan is right for you or when you are preparing to tackle your repayment, it is important to keep in mind that any minimum payment made primarily goes towards interest first. Once the interest is paid, then these payments will be applied in full to your principal balance.
HOW TO LOWER THE TOTAL COST OF YOUR STUDENT LOAN
The challenging part of all of this is that we rarely take enough time to understand the consequences of debt and do not have a solid plan to repay it. So when we fall into debt, too often we get stuck in a loop of just paying interest.
In order to lower the cost of your total student loan, it is important to look at the numbers. Use a student loan interest calculator from BankRate or NerdWallet to see how much interest your loan is accruing daily and monthly. Then, see how much interest you would end up paying by the end of your loan term. This information can be the most eye-opening. What happens if you start paying a month from now? A year from now? How much interest can you expect to pay if you’re on an income-based repayment plan? Do you want to tackle the loan with the highest interest first?
In the end, depending on the size of your loan, you could end up paying the government or a private lender thousands more in interest. Does the lender really deserve that? Wouldn’t you want that money for something more valuable?
Make a plan. Create a budget. Make payments early as soon as you can and, if you are able, pay more than the minimum amount to keep the total cost of the loan down.