How Does Student Loan Interest Work?

Understanding how student loan interest works can help you narrow your loan options. In fact, knowing how much a loan will actually cost could be the difference in spending or saving thousands of extra dollars.

It’s probably been a while since you talked about interest in your fourth-grade math class. But that’s ok! We’ll explain it, and we promise to keep it simple.

What Is Student Loan Interest?

Interest is the price you pay to borrow money from a lender. An interest rate is used to calculate how much you are charged per dollar you borrow, and it is often expressed as an annual percentage rate (APR).

Lenders charge interest to offset the risk they take when loaning money. It also compensates them for the things they could be doing with their money if they weren’t lending it to you. In the case of student loans, some of the interest you pay may provide money your lender uses to make loans to other students.

Student loan interest works the same way as interest you pay on a credit card or auto loan. It can be fixed or variable depending on whether you have federal or private student loans. It can also be simple or compound. Most interest rates are affected by rates set by the Federal Reserve and factors in the economy. Interest on private student loans can also be affected by your credit score.

Are Interest Rates on Student Loans Fixed or Variable?

Federal student loans have fixed rates, meaning that your interest rate will stay the same throughout the life of your loan. Private student loans can have fixed or variable rates. With a variable rate, your interest rate can change. If you’re using private student loans, you’ll need to ask your lender whether they offer fixed or variable rates.

Are Student Loans Simple Interest Loans?

All federal student loans and most private student loans use simple interest. But what does that mean?

Simple interest means that your interest never adds up (or “accrues” in financial language). When you make a payment on your loan, the payment covers your interest charges first and whatever is leftover goes toward your loan’s principal. That way your loan balance doesn’t increase.

With compound interest, any unpaid interest charges are added to your loan principal. Then you are charged interest on this new balance — the original balance plus any accrued interest. Credit cards often use compound interest. They calculate interest charges daily so that tomorrow you’ll be charged interest on today’s balance plus interest that accrued today. 

In this way, your debt can grow much faster if you’re not making large enough payments to cover your interest charges and reduce your principal.

How Is Interest Calculated on a Student Loan?

To calculate the interest on your loan, you need to divide your interest rate by the number of days in the year. This gives you the amount of interest that accrues daily. Multiply this by your loan balance. Then multiply again by the number of days since your last payment. This final number is the amount of interest you’ll pay for that period.

For instance, say you have a $12,000 student loan through PenFed and our partner, Ascent. As of December 2022, the APR on fixed-rate student loans through Ascent ranges from 4.62% to 16.75%. For our example, we’ll assume a 10% rate.

You’ve paid some on the loan but still owe $10,000. To find what you’ll pay in interest each period, follow these steps:

1. Divide your interest rate (10%) by 365 and you’ll get a daily rate of 0.0002739726.  
2. Multiply 0.0002739726 by your balance ($10,000) and you’ll get 2.7397260274. 
3. Multiply 2.7397260274 by the number of days since your last payment. That gives you 82.1917808219. 
   • If your last payment was last month, then this number will be 30 or 31. We’ll assume 30 days for our example. 
4. Round up 82.1917808219 and you’ll have your interest payment for your current payment period: $82.19. 

Does Interest Accrue on Student Loans While in School?

Whether interest accrues on student loans while you’re in school depends on the type of loans you have. Interest does not accrue on subsidized federal student loans while you are in school because it is paid by the U.S. government until you graduate. Interest does accrue while you’re in school on most other federal and private student loans.

In some cases, interest that accrues can be capitalized, meaning it’s added to your loan principal balance. You may then have to pay interest on the principal of your loan and the capitalized interest, too.

Capitalization can greatly increase how much you must repay on student loans, so it’s important to know that it usually occurs when:

• The grace period ends on federal student loans
• Periods of deferment or forbearance end
• Loans are consolidated or refinanced
• You select some income-driven repayment plans

When Do You Start Paying Student Loan Interest?

You start paying student loan interest when you start repaying your student loan. Most federal student loans offer a six-month grace period before you have to start repayment, giving students time to find jobs and adjust to life after college before making payments. However, interest begins accruing on unsubsidized loans while you are in school. If you choose to defer payments after your six-month grace period, interest can accrue then, too.

Private lenders set their own standards for who qualifies for the loans they offer, what interest rates and fees they charge for those loans, and how repayment is structured. Some private lenders require you to start repayment while you are in school. Others require you to pay interest on the loan but may let you defer payments on the principal until you graduate. Still others allow you to defer payments on both the principal and interest of your loan.

Check with your specific lender for details if you’re using private student loans. 

The Takeaway

Figuring out student loan interest takes a minute, but once you’ve got it, you’re empowered to make better choices about which loans you borrow. And that’s setting yourself up for better financial success right from the start.