How does student loan interest work?

A guide to student loan interest and calculations.

When you apply for a student loan, you’re trying to borrow money to pay for your education. Like any loan or student credit card, you usually have to pay that money back. But when you do, you may be responsible for more than just what you originally borrowed. That’s because of student loan interest.

Interest charges are something you’ll probably deal with until your loan is paid off. But there are many variables that can affect when it accumulates and how much you owe. Keep reading to learn how interest is calculated and how it may influence your repayment schedule.

How is interest calculated on student loans?

To understand the basics of how student loan interest is calculated, you’ll need some background on a few important elements.

First, a couple of terms: The principal is the amount of money you originally agreed to borrow. And an interest rate is the percentage you’re charged for borrowing that money. It’s usually expressed as annual percentage. 

Now, here’s where things might get confusing. 

Your interest rate may be shown as an annual percentage. And loan payments are typically made each month. But student loan interest can actually build up, or accrue, on a daily basis. If that’s the case, you’ll have to do some quick math to figure out how much interest you’ll owe. 

To start, you’ll need to find your interest rate factor. It’s also known as your daily interest rate because it’s the amount of interest that accrues every day. You can find it by dividing your annual interest rate by the number of days in the year. 

Here’s what that would look like for someone with a 5% annual interest rate:

Graphic showing how to calculate a student loan daily interest rate, also known as interest rate factor: Daily Interest Rate = Annual Interest Rate ÷ Number of Days in the Year

Once you have your daily interest rate, you can calculate the amount of interest that accrues between loan payments.

  1. First, multiply your outstanding principal by your daily interest rate.
  2. Then multiply that number by the days since your last payment.

The example below is based on someone who owes $40,000 with 5% annual interest. Under those circumstances, the borrower would owe about $165 in interest for that month. That breaks down to about $5.50 per day.

Graphic showing the calculation for monthly interest on student loans: Monthly Interest = (Outstanding Principal x Daily Interest Rate) x Days Since Last Payment

When does student loan interest start accruing? 

There’s no set time when student loans start adding interest. It depends on the type of student loan. 

Subsidized federal student loans are for students with greater financial need. If you have one of those, the Department of Education will take care of the interest while you’re in school. There may also be a grace period of six months after you leave school during which you aren’t responsible for paying interest.

But private loans and unsubsidized federal student loans might work differently. Interest on those loans may begin to accrue as soon as you receive funds.

Typically, interest accrues until you pay off your loan. So making payments while you’re in school could help you avoid owing more than you expected.

How much of student loan payments go toward interest?

Generally speaking, your minimum monthly payment will remain the same over the term of your loan. That’s because of a process known as amortization, which determines what percentage of your payments goes toward interest versus what goes toward the principal.

At first, a good portion of your monthly payments will go to interest and fees. Over time, however, you’ll start working down the principal on your loan. As you do, the amount of interest you accrue will decrease, and more of your total monthly payments will go toward paying off your student loan’s principal.

What else affects student loan interest?

There may be multiple student loan options available, and which loan you get can influence how much interest you’ll pay. Here are some other things that can affect student loan interest that you may want to consider.

Fixed interest rates vs. variable interest rates

Fixed interest rates are exactly that—constant for the entire life of your loan. Variable rates, on the other hand, can move up and down depending on general economic conditions. 

If you get a federal loan, it will be at a fixed interest rate.

Private loans, however, might have a variable rate. Typically, lenders will tie their variable interest rate to an index or benchmark rate. Lenders may then add in their own percentage, called a margin, to determine your total rate.

Broadly speaking, you’ll pay a more predictable amount of interest with a fixed-rate loan. While it’s possible to start at a lower interest rate with a variable loan, the fact that they can change means that you could end up paying more. Generally, federal loans are said to have lower interest rates.

Simple interest vs. compound interest

Simple interest loans charge interest on the principal balance of your loan and nothing else. Current federal student loans work this way. The same is true of many private loans.

But some private loans may compound interest. This means that they charge interest on the principal and any unpaid interest. In other words, you’ll pay interest on interest.

Interest rates and credit

Most federal loans don’t require a credit check. All their interest rates are also predetermined. And remember: Those rates are usually lower than the rates of private loans.

Credit scores do come into play when you’re looking for private student loans, though. They can influence how much you’re able to borrow and what interest rate you’re offered. 

Many private lenders require borrowers to have a co-signer who is ultimately responsible for the loan. The higher a co-signer’s credit score is, the lower interest rates are likely to be. 

Similarly, if you apply for a private loan without a co-signer, having a good credit score yourself could help you access the lowest rates possible. But many young people have not had a chance to establish credit yet.

Like other loans, all student loans can affect your credit, according to the Consumer Financial Protection Bureau. Make your payments on time, and you could see your credit improve. Miss your payments, though, and it could have a negative effect on your score. 

There are even times when paying off student loans could have a temporary negative effect. But the long-term benefits of paying off the debt are probably more beneficial.

What is capitalization on a student loan?

In some circumstances, your lender may capitalize interest. This means they’ll add unpaid interest to the principal of your loan. When new interest is calculated, it will then be based on the sum of your outstanding principal plus the capitalized interest.

If you’re making regular payments, you may not have to worry about capitalization. But there are some instances in which interest may go unpaid. Here are a few examples:

Generally speaking, making payments during school—before the capitalization period begins—can help reduce the amount of your loan that is capitalized. Similarly, making payments during a deferment period could help minimize capitalization on student loans.

Paying off student loans

Interest may increase the amount of time it takes to pay back your student loan. But with a bit of strategy, you might be able to stay ahead of the curve. Here are a few tactics you can consider when paying off your student loans:

  • Start paying off loans in college. Paying off your loans sooner could put you in a better position after graduation. It can help keep your interest from capitalizing, which may prevent your loan principal from increasing while you’re attending school.
  • Pay off as much as you can. Paying more than just your monthly minimums puts more money toward your loan’s principal balance. And that can reduce accrued interest and help you repay your loan faster.
  • Prioritize high-interest loans. If you have multiple loans, prioritizing your high-interest loans allows you to tackle the fastest accruing interest first. This strategy is sometimes called the debt avalanche method. It’s still important to pay at least the minimum every month on all your loans. But the avalanche method can help the interest you accrue go down quicker, saving you money.
  • Refinance private loans. When you refinance, you’re getting a new lender to pay off multiple loans for you. It allows you to transfer all—or most—of your debt to a single lender. If you aren’t able to get a better interest rate and payment terms, though, it might not be the right solution. And if your new loan has a variable interest rate, remember that it could change over time.
  • Consolidate federal loans. Consolidating your federal loans is similar to refinancing in that you’re combining multiple loans into one. The potential advantage is that switching to one loan payment can lower your monthly minimum and make paying down interest a simpler process.

Student loans can take anywhere between 10 and 30 years to pay off. These techniques may be able to help you keep your interest payments in check. And they might also be useful for reducing the total amount you’ll have to pay in the long run. But some actions may affect the time it takes for you to repay your loan—in one direction or the other. 

Benefits of understanding student loan interest

Student loan interest can be a lot to deal with. So it’s a good idea to examine the details of your loan agreement before accepting it. Talking to a financial expert, if possible, could help too. 

Even if you’re trying to figure it out for yourself, understanding how interest works and knowing how you can calculate your interest payments can give you an advantage. 

You can make the most of that advantage by staying up to date with your student loan payments to pay down interest and help keep your debt under control. What’s more, timely student loan payments may benefit your credit. And that can come in handy when you need to borrow money or make a major life purchase, such as a home, in the future.

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