How Does Student Loan Interest Work? It is very important for you to know the answer to this question before taking a student loan.
You should have a clear idea of how to repay the loan in the future.
The interest rates of federal student loan and private student loan are different. Repayment terms are also different.
The interest rate on federal student loan is much lower than that of the interest rate on private student loan. If you know how interest works, you will have less trouble paying off debts in the future.
Terms in a credit agreement
Student loan interest rates can be fixed and variable. In this case it is seen that the interest rate on federal loans is fixed and the interest rate on private loans is variable.
The interest rate varies from organization to organization.
The promissory note or credit agreement mentions all the terms and conditions. So it needs to be verified very well.
Agreeing with the promissory note without verification means you are taking out a loan on their terms and you may face problem in future.
According to that condition, the loan has to be repaid with interest at a predetermined period at a fixed or variable interest rate.
Terms in a credit agreement
- Amount of money that you want to borrow
- Interest rate of the loan
- How interest accrues (daily vs. monthly)
- Payment schedule
- First payment due date
Read More – How to Get a Student Loan?
How to calculate student loan interest?
The institution from which you will take a loan will fix the interest rate. You can borrow from them if you agree with their terms and conditions.
If you take out a federal student loan, the interest rate on your loan will be lower.
Let’s see how you calculate student loans.
Federal student loans follow simple daily interest formula. Suppose you borrow $10,000 at 5% annual interest. Then your interest per year will be $ 500 ($10,000 x 0.05 = $500), the amount of interest per month will be $41.67 (500/12 = $41.67). Loan accrues per day will be $1.36 (41.67 / 365 = $1.37).
Compound interest is calculated on the principal and accrued. This means that interest will be calculated on your entire balance. Suppose you had some money left over in the previous year so the next year due amount Will be added to the principal. Then interest will be calculated on both the principal and accrued.
For example, you borrowed $10,000 at 5% interest and the interest due after one year is capitalized, since you could not pay $500 in the first year, interest will be calculated on $10,500 ($10,000 + $500) the following year.
Read More – Types of Student Loans: Which Is Best for You?
Capitalization will increase your interest costs. You must be aware of this. Because if you do not pay your accrued interest on time then unpaid interest builds up and is capitalized or added to the principal loan account.
For federal student loans, capitalization of unpaid interest occurs:
- After the grace period.
- After the forbearance period.
- If you get deferment then after a period of deferment.
- If you leave Income-Based-Repayment (IBR) plan.
For private student loans
- When the grace period ends
- After a period of deferment and forbearance.
But everything will depend on your lender. You should discuss these issues with them and get a clear idea.
How interest accrues on student loans?
Students have to pay interest on your loan from the time you take out the loan. But since students do not have a full-time source of income, they are given the opportunity to repay the loan with interest after a certain period of time.
Subsidized federal loans, unsubsidized federal loans, and PLUS loans is charged daily. When the federal government takes the responsibility for interest accrued while you’re in school, it is called a subsidized federal loan. To get this loan students must enroll in school at least half-time.
Subsidized loans do accrue interest, but the interest is paid by the US Department of Education. You do not have to pay any interest and principal while you’re in school. After the six-month grace period of college admissions your payment schedule will begin.
And if you receive unsubsidized federal loans, you will have to pay your interest. Start accruing interest from the time you take out a loan.
Advice to reduce total interest payment
Pay interest regularly
One of the benefits of taking out a federal loan is that you don’t have to pay interest while you’re in school and up to a six-month grace period.
Your interest will continue to accrue but must be paid after this period. So if you pay interest regularly then you will not have to spend large amount of money after grace period.
You should choose a shorter repayment term
Shorter repayment term will help you to reduce interest rates. The repayment term of a federal loan is usually 10 years, which can be extended up to 30 years. But the term of private loan varies from institution to institution. It is mentioned in the loan agreement.
In this case, if the loan repayment period is short and your credit is good, then the interest rate will be slightly lower.
If you have capability makes Extra Payments
You will be given enough time to repay the loan and there is no penalty on the student loan. If you pay extra, the amount of interest will decrease.
Especially in the case of private loans, it is better to repay the loans early for those who follow the compound interest formula.
If you make an additional payment, the amount of principal loan will be reduced and the amount of interest will also be less.
Consider loan Refinancing
There are many lenders who refinance private loans. Low interest refinance will help to reduce your total interest amount. If your credit score is good or you can collect good cosigner then lender may refinance you at low interest.
The federal government provides loan consolidation facility but it does not reduce average interest rates on student loans.
Refinancing federal student loans into a private student loan will not be good for the borrowers as they may lose access to the superior repayment benefits on federal student loans. Such as, loan forgiveness, income-driven repayment plans etc.
PSLF (Public Service Loan Forgiveness)
If you are a employee of a U.S. federal, state, local, or tribal government or not-for-profit organization, you will enjoy the Public Service Loan Forgiveness Program. Federal student loans program are also eligible for the Public service loan forgiveness (PSLF) program.
However, to be eligible, you have to make at least 120 qualifying monthly payments under a qualifying repayment plan.
Income-Based Repayment (IBR)
If your income is lower than federal student loan payments, you can take an Income-Based Repayment (IBR) plan. With this plan you can set monthly student loan payment in a way that will help you repay the loan on time.
The payment amount under this plan is a percentage of your discretionary income. This percentage varies according to the plan.
There are four Income-Based Repayment plans –
- Revised Pay As You Earn Repayment Plan (REPAYE Plan)
- Pay As You Earn Repayment Plan (PAYE Plan)
- Income-Based Repayment Plan (IBR Plan)
- Income-Contingent Repayment Plan (ICR Plan)
How Does Student Loan Interest Work? Hope you got the answer to this question from the discussion above. Many are now thinking if I should take out a student loan.
In this regard, I would say that taking a loan or not will depend on your financial needs. There is no need to take out a loan if you can manage your education expenses without a student debt. Because borrowing means your extra costs.
Although the federal interest rate has come down here, the interest rate on private student loans has continued to rise.
In a 2017 study on student loans, New America found that the average interest rate on student loans was 5.8%. So now you can realize that borrowing means extra costs.
Take another look at the example of how interest rate is calculated –
Suppose you borrow $10,000 at 5% annual interest. Then your interest per year will be $ 500 ($10,000 x 0.05 = $500), the amount of interest per month will be $41.67 (500/12 = $41.67). Loan accrues per day will be $1.36 (41.67 / 365 = $1.37).