Here’s exactly how student loan interest works

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Back when you signed the dotted line and took out your student loans, how well did you understand the terms?

Maybe things were a little fuzzy, but you knew you needed the loans to pay for college. Or maybe you’re a parent who wanted to help your child pay for an education and a better future. Now you’re wondering how much you’ll have to pay back on your Parent PLUS loans and you’re asking yourself: how does interest work?.

Whether you paid for your education or helped your child, interest rates are one of the more complicated aspects of student loans. How interest rates are set, how interest accrues, and how payments are divided between your principal balance and interest charges can be difficult to grasp.

But understanding how student loan interest works is an important step in managing your debt.

How does student loan interest work?

When new student loans are issued, the borrower signs a promissory note that explains the terms of the loan. Every part of this document is important to read and understand, as it determines how much you owe and when your payments are due. This applies to Parent PLUS loans and their interest as well.

The most important terms to look out for are:

  • Disbursement date: The date the funds arrive and interest starts accruing
  • Amount borrowed: The total amount borrowed in each loan
  • Interest rate: How much you have to pay to borrow the funds
  • How interest accrues: Whether interest is charged daily or monthly
  • First payment date: When you have to make your first loan payment
  • Payment schedule: How many payments you have to make

Lenders understand that most full-time students do not have an income, and if they do, it is not enough to cover student loan payments while in school. As a result, it’s often possible to avoid making payments while you’re in school.

For students that demonstrate need, the government offers subsidized Direct loans. If you qualify, the government pays your interest while you’re in school, so your balance doesn’t grow. Once you graduate, though, the interest becomes your responsibility.

Unsubsidized loans, meanwhile, charge interest from the day the loan is disbursed. Since you aren’t required to make payments, interest will build up, and you’ll graduate with a loan balance higher than you started with.

Do Parent PLUS loans accrue interest the same way? Unfortunately, there are no subsidized loans for parents. Additionally, regular repayment begins 60 days after the loan is completely disbursed.

How is student loan interest calculated?

Your required loan payment will be the same each month. However, when you make a payment, interest is paid before any money goes toward reducing your principal. The remainder of your payment is applied to your principal balance.

Your interest rate is divided by the number of days in the year to get your “interest rate factor.” The interest rate factor is then multiplied by your loan balance and then multiplied by the number of days since your last payment. The result is how much interest you are charged for that period.

How is student loan interest applied?

As you make payments on your student loan, your balance and the amount of interest you accrue will drop. With lower interest charges, more of your payments are applied to your principal. Over the life of your loan, your interest paid will decline each month, which accelerates your principal payment. That’s how it works with amortization — basically a fancy way of saying “paying down principal on a loan.”

Remember, your payment amount goes toward interest and any outstanding fees before it reduces your principal.

If you have an unsubsidized loan or are past the subsidy period, your loan payoff date requires you to make the same minimum payment each month. If you are on a payment plan or have deferred payments, interest continues to accrue. This amount is added to your principal, increasing your student loan balance.

If you are able, it can make sense to pay at least the interest each month. If you don’t, your loan balance will continue to grow and you will owe interest on the interest you didn’t pay in previous months.

In fact, if you have the ability, making interest payments while you are in school can save you money in the long run.

The difference is even more pronounced when you think of interest paid on a Parent PLUS loan. Let’s say you take $5,000 in Parent PLUS loans each year your child is in school. Here’s how the interest builds up with a 7% interest rate:

student loans

These calculations were made using Sallie Mae’s accrued interest calculator and assumes the current federal rate on Parent PLUS loans will hold for four years. It also assumes you will keep accruing interest for four years on your child’s freshman year loan, three years on the sophomore loan, two years for the junior year, and 12 months on the final loan.

As you can see, you borrowed $20,000, but if you put off repayment until after your child graduates from college, your loan balance will grow to $23,500.

What happens if you don’t make full payments each month?

It’s important to remember that making partial payments will count as a missed or late payment on your credit report and may cause you to go into loan default.

If you are struggling to make payments and can’t figure out a way to afford them, you can look into an income-driven repayment plan. The REPAYE program, for example, limits your payments to 10 percent of your discretionary income.

Using Student Loan Hero’s Income-Based Repayment calculator, you can see how it can help with your monthly cash flow. However, you have to watch out: Interest remains a factor, and the longer you are subject to interest charges, the more you repay in the end.

student loan payments

The example above assumes you have an adjusted gross income of $30,000, that your income rises 3.5 percent each year, and that you have $30,000 in federal student loan debt at an average interest rate of 4.26%.

And what happens if you defer your student loan payments? Consider your Parent PLUS loans. Our student loan deferment calculator can help you figure out how much extra you pay if, for example, you have $20,000 in debt at 7% and defer for 12 months.

student loan debt

As you can see, deferment adds $1,400 to the total when you’re on a 10-year repayment.

While it is possible for you to defer payments when you have a Parent PLUS loan, the fees and interest might mean it makes more sense to avoid it if you can make room in your budget to keep paying down your debt, or even looking into refinancing at a lower interest rate if possible.

How are extra student loan payments treated?

When you make your monthly payment, you are given the option to pay extra. If you do, that extra payment is applied directly to the principal, which will reduce your interest in the future.

Any other extra payments made throughout the month are treated as normal payments. That is, your payment is first applied to interest you accrued since your last payment and then your principal. Double-check your lender’s payment policies to make sure any extra payments are really going to pay down your principal.

Don’t underestimate the power of early payments. Paying an extra $50 or $100 each month can save you thousands of dollars in interest, depending on your loan terms. Check out the student loan prepayment calculator to see how much you can save by paying a little more every month.

Compound interest is a powerful weapon

Putting off payments or just making the minimum each month will leave you with a big interest cost over the life of your loan.

Use your new knowledge of how to calculate interest on a loan and how compound interest works to pay off your loans early. You work hard for each paycheck. Pay more today so you can save even bigger later.

Eric Rosenberg and Christy Rakoczy contributed to the reporting for this article.contributed to this article. 

*Sallie Mae Disclaimer: Click here for important information. Terms, conditions and limitations apply.
†The Sallie Mae partner referenced is not the creditor for these loans and is compensated by Sallie Mae for the referral of Smart Option Student Loan customers.

This article originally appeared on StudentLoanHero.com and was syndicated by MediaFeed.org.

Featured Image Credit: Damir Khabirov / iStock.

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