June 5, 2021

How Does Student Loan Interest Work?

All loans come with interest. The interest is the amount you pay for the service of letting you borrow the money. When you take a loan, you’ll ultimately pay more than what you borrowed. Depending on how you treat your student loan interest, the amount you’ll need to pay off the loan will be greater. Understanding how it works will give you an advantage in paying off your student debt.

Inner Workings of Interest

The interest is a percentage calculation of your principal, also known as the money you borrowed. The amount you’ll pay depends on the agreement you made during the loan. Some loans have a fixed interest rate for the entirety of their lifespan. Others are variable and will change depending on what you agree upon.

Ideally, you’ll want a loan that has a low-interest rate. A low-interest rate means that you’ll pay less over time. Student loans are more expensive and have higher interest rates due to the risk involved. Since students have no means of paying until they get a job, lenders make up for it by charging a higher interest rate. When you begin paying a loan, you’ll have to pay two amounts.

  1. The principal
  2. The interest rate

Federal loans are usually fixed rates, meaning they set interest, and there are no changes for the entirety of the loan. When it comes to private loans, they are either fixed or variable. Before you accept a loan, make sure to read everything in the agreement. It will have important details such as:

  • Payment schedule
  • Payment due dates
  • How your loan accumulates interest
  • The amount you borrowed
  • The interest rate

Fixed Interest Loans vs. Variable Interest Loans

Fixed student loan rates range from 2.75% to 5.3%. The rate will depend on several factors, including your academic history, university, and credit history. Federal loans only operate within a fixed rate, and these provide some advantages:

  • Easier to refinance the loan in the future to change your interest rate
  • You can reduce interest when you sign for an autopay system
  • Easier budgeting since you already know the calculations

The only downside with fixed interest rates is that you won’t get a lower interest rate over time. With high interest rates on student loans, the best option to lower your interest rate is refinancing.

Variable interest rates are available through private lenders. The advantage of these is that you can get a low interest rate if you line up at the right season. However, since they are variable, interest rates can also increase to a higher rate than fixed rates. It also makes it challenging to pay around them because you can’t set a fixed budget.

Subsidized Loans

One of the advantages of getting a federal loan is a subsidy. Since you won’t have a big enough budget to compensate for the payments, the government can subsidize. You can put off making payments until you finish school if you remain a full-time student. The subsidy will pay for any accruing interest until six months after you finish studying.

Do note that subsidy caps at $23,000 for the loan’s duration. You must also show that you cannot produce the minimum payment amount, which will signify that you need a subsidy.

For unsubsidized loans, you’ll have to pay the interest rate at all times, meaning that it can increase your debt if you don’t make regular payments. The only positive behind this is that since you’ll need to pay interest, it comes at a lower rate than other plans.

Grace Period

Federal student loans are also an appealing first option because they give you a grace period. These options are mainly available for graduate students and those who have children. It is also available for those who have to serve active military duty. The grace period lasts for six months, and you have to return to school before it ends.

Calculations

Federal student loans have a calculation because they have a fixed interest. Congress sets the rate, so the terms are the same for everyone in the same plan. The interest formula is a daily rate as opposed to the usual monthly rate for other loans. To compute it, you multiply your principal to the interest and divide it by the number of days in a year. For example:

You have a loan of $4000 which is your principal, and your interest rate is 5.3%.

4000 x 5.3% (0.053) = 212

You then divide that number by the number of days in a year which is 365.

212/365 = $0.58

Your loan generates 58 cents a day of interest.

Variable Loans

These interest rates vary depending on current rates and your loan principal. They also usually give you an annual interest rate calculation. Here’s how you calculate how much interest you generate in a month:

Divide your annual interest rate by the number of days in a year. If you have a 5% interest rate, .05/365 = 0.00014

You then multiply the remaining loan balance with the daily interest rate of 0.00014. Let’s say you have a $5000 loan.

$5000 x 0.00014 = 70 cents

You then multiply the daily amount by the number of days since your last payment. If your previous one was 30 days ago, then .7 x 30 = $21 of interest in one month. You will need to change your calculations if the interest rate changes. Knowing the formula for calculation is ideal if you want to prepare early for your loan payments.

For both types of loans, paying your principal will reduce the interest rate significantly. If you reduce your $5000 loan to $4000, the interest rate calculates on the remaining principal. For this reason, it is ideal to try and pay off a student loan as soon as possible to lower your monthly payments.

Tips For Minimizing Student Loan Interest

While you cannot avoid paying interest on your loans, there are ways to lower the interest you need to pay. Your repayment plan considers duration, total loan amount, type of loan, and interest rate. Here are some ways you can save money and minimize interest:

Pay More and Pay Often

Instead of adhering to the usual timetable, inform your lender if you are making payments to your principal in advance. By paying twice as much or paying more than the minimum, you reduce your principal at a faster rate. A lower principal means lower interest rates. You won’t be able to do this immediately as a student. Even then, starting this practice early will ensure you pay the loan faster.

Try To Pay While You’re In School

You may find many financial opportunities while you are in school. You don’t need to pay the interest rate in some cases, but you can still opt to make payments. If you do so, you lower your interest rate significantly, giving you more breathing room after you’re finished with your studies.

Ask For Interest Rate Reductions and Discounts

Some lenders offer discounts and other promotions that you may not be aware of. You can ask them if there are ways to lower interest rates. For example, some lenders offer a reduction if you enroll in an autopay system. The interest rate reduction applies as long as you make timely payments.

Shop Around

While federal loans offer some benefits because of subsidies, you can always shop around for private student loans. There are private student loans that also have subsidies. It’s even possible to get a loan with a low interest rate. To entice students, some also provide other benefits like discounts.

Prioritize Subsidized Loans

Having a subsidized loan means you won’t have to worry about interest accruing in school. It helps lower the amount you need to pay after you graduate and won’t hurt your finances while studying. Subsidized loans are the best option to give you breathing room. Many federal loan offers have subsidies, though some private loans also offer them.

Be Wary of Compound Interest

Some private lenders use compound interest. If you leave any unpaid interest, it will add to the principal when computing your next month’s rate. If you aren’t paying attention, it can lead you quickly into a large debt. If you’re getting a loan from a private lender, make sure that your plan doesn’t have any compound interest agreements.

How Does Student Loan Interest Work? Putting It All Together

Knowing how to compute your interest rate will help you understand how much you need to pay on top of the money that will lower your principal. Once you get used to the computations, it is a simple process. If you have a loan with variable interest, make sure to update the rate to reflect the amount you need to pay. You should also be aware of any repayment plans they are offering.

Repayment can help lower the interest rate significantly. At that point, you’ll have established a good credit history through your years of study. It’s in your best interest to lower interest rates as soon as possible to help you pay off the loan faster.

Sources:

https://www.collegeavestudentloans.com/resources/how-student-loan-interest-works/

https://www.thebalance.com/how-does-student-loan-interest-work-4777197

https://www.investopedia.com/how-to-calculate-student-loan-interest-4772208

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