How Does Student Loan Interest Work?

Just like your mortgage, a student loan charges interest on your loan balance. How much you pay in interest depends on your loan type, your interest rate, your loan terms, and several other factors.

It’s important to understand how student loan interest works on your particular loan so you can anticipate how much it costs to pay them off, as well as ways to lower the student loan interest you pay.

We’ll break down the exact process used to calculate your student loan interest, how interest works on several different types of student loans, how interest is applied to your loans, and several ways to lower the amount of interest you pay.

How interest on student loans is calculated

It can be calculated in several different ways, depending on your loan provider and the type of loan you have. Here’s how it works:

Simple interest vs. compound interest

Simple interest is calculated by multiplying the loan balance by the loan interest rate. This shows you how much interest you will be charged per year.

For example, if you have a $20,000 student loan at a 10% interest rate, you would pay $2,000 per year in interest — $20,000 multiplied by 10% equals $2,000.

With compound interest, you calculate the same equation as simple interest but then add the interest to the balance of the loan. This is known as “capitalization,” and this increases the amount of interest paid over time.

For example, if you have a $20,000 student loan at a 10% interest rate, you would accrue $2,000 in interest that first year. But then the $2,000 balance is added to your loan, and in year two, you would pay 10% interest on a $22,000 balance. This would mean your interest charges will be $2,200 in year two

Most student loans use simple interest, but some private student loans and certain scenarios for federal student loans use compound interest, which can add up.

How does student loan interest work on subsidized loans?

Federal student loans may offer some borrowers subsidized student loans. With these loans, the government pays your interest charged while you’re in school. As well as during the loan grace period after school. This means you don’t have to make interest payments during that time, and your loan balances won’t go up.

In addition to no interest accrual during school and the grace period, subsidized federal student loans also don't accrue interest during periods of deferral. Subsidized loans are only available to borrowers who fill out the Free Application for Federal Student Aid (FAFSA) and are deemed in “financial need.”

How does student loan interest work on unsubsidized loans?

Federal student loans also offer unsubsidized student loans to borrowers who don’t qualify for subsidized loans. And borrowers who need more than the subsidized annual limits to pay for college costs. Unlike subsidized loans, interest accrues immediately on unsubsidized loans. This means that your loan balances will grow during school or any periods of deferment if you do not make any interest payments. 

When does interest start accruing?

Student loan interest begins accruing at different times, depending on your loan and circumstances. Some loans start accruing right away, while others don’t.

For subsidized federal student loans, interest does not accrue. Interest charges are paid for by the government while you are in school and during deferment.

But for private student loans and unsubsidized loans, interest starts accruing as soon as the funds are disbursed.

This is important to note because most student loans don’t require payment while you are in school. However, if interest is accruing, your student loan debt will grow and you’ll end up paying more interest in the long run.

Student loan interest capitalization

Student loan interest that gets added to your overall student loan balance is called “capitalized” interest. When student loans enter repayment, the accrued interest is “capitalized,” causing your student loan debt to be much higher. And you will pay interest on that higher balance.

The rate at which your loans capitalize will vary based on your lender, the type of loan, and your loan-specific terms and conditions. While some lenders capitalize annually, some do it more often, such as monthly. This can have an impact on how much interest you end up paying on your loans.

For example, if your student loan balance is $20,000 with a 10% interest rate, and you don’t make interest payments while in school, you may accrue interest monthly. At a 10% interest rate, this would mean $166.67 is added to your loan balance monthly. This makes your loan balance increase even faster.

Related: How do student loans work?

How to pay less student loan interest

Interest on federal and private student loans alike can cost you tens of thousands of dollars over the life of your loan. Here are a few ways to pay a lot less student loan interest:

Pay on time

Paying your student loans on time can help you save money in several ways:

• Your loan will continue to qualify for student loan forgiveness. Most forgiveness programs for federal loans require no missed payments, so paying on time could help you save thousands.
• You will not pay any penalties. If you make late payments, penalties may be assessed. Paying on time avoids this.
• You will qualify for subsidized deferments. If you have any subsidized loans, making on-time payments ensures you still qualify for the interest to be paid for you during qualified deferments.
• Less capitalized interest. Interest will capitalize, and making late payments simply adds to your student loan balance. Paying on time ensures less interest capitalizes over time.

Sign up for autopay

Most student loan lenders offer a small discount for setting up Autopay. This can be up to a 0.25% reduction in your student loan interest rate. Which will save you on the total amount of interest paid over the life of the loan. This will also help you avoid missing any payments.

Make early (or extra) payments

Paying off your student loans while you’re in school or during any grace period or deferment will help lower the amount of interest that accrues. And if you have a subsidized loan, your payments will go directly toward your principal. Lowering the amount of time it takes to pay off your loans. Even making “interest-only” payments while in school will prevent interest from capitalizing once you enter repayment. Which can be a massive interest savings over the life of your loan.

Once you are in repayment, making extra payments is a great way to pay off your loans quicker and to prevent more interest from accruing. Since there are no prepayment penalties, you can pay off your student loans as fast as you’d like. 

Your student loan payment first applies to the interest on your loan, then to the principal loan balance. Extra payments therefore will pay down your principal balance much faster, and reduce the overall interest paid.

Opt for shorter loan terms

While most student loans offer a standard 10-year repayment term, some private student loans can go as high as 30 years. Longer loan terms mean more interest will accrue and capitalize over the life of your loan. Choosing to pay off your loans quicker will apply more of your payment toward principal each month, and drastically lower the interest paid over the life of your loan.

Request loan forgiveness

If you qualify for a loan forgiveness program, you can save a large amount of money on interest payments, as well as pay much less on your student loans overall. Public Service Loan Forgiveness (PSLF) will forgive your loans after 120 consecutive on-time payments if you qualify. And income-driven repayment plans will forgive remaining loan balances after 20 years for undergraduate loans and after 25 years for graduate loans. Both of these options can save you thousands in interest (and principal) payments.

Refinance your student loans

While refinancing federal student loans isn’t always the right choice, if you don't qualify for any forgiveness programs, you may consider it. Refinance can help lower interest rates in certain cases and you can also opt for a shorter repayment term. Lower student loan interest rates mean paying less interest over the life of your loan.

FAQs

Why do I owe more than I borrowed even when I’ve been making payments?

Some payment plans pay less than the interest that is charged on the loan. Income-driven repayment plans, for example, may lower your monthly payment, but interest will continue to accrue. If your monthly payment doesn’t cover the monthly interest, then your loan balance will continue to go up, even though you are making regular payments.

Are interest rates on student loans monthly or yearly?

The student loan interest rates that you see are a monthly rate. That said, interest on federal student loans is accrued daily. To calculate this, you take your total loan balance multiplied by your interest rate, then divide by 365 (days per year). This will show you how much interest accrues daily. 

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