How Does Student Loan Interest Work?
Categories: Blog, For Students, For College Students, For Grad Students
What is student loan interest, and how does it work?
If you’re exploring different ways to pay for college or graduate school, understanding student loan interest is an important early step. In this guide, we’ll explain the mechanics of student loan interest, equipping you with the knowledge needed to confidently navigate your repayment journey.
Before getting started, we’ll briefly explain two key terms you should be familiar with:
Interest is the price paid for the use of borrowed money. It is typically expressed as a percentage rate over a period of time.
APR stands for Annual Percentage Rate. The APR gives you an “apples-to-apples” comparison of loans with different terms, represented as an annual rate that includes repayment plans, repayment terms, the interest rate and any origination fees (unlike Ascent, some lenders actually charge origination fees to apply for a loan). Ascent publishes a range of APR’s for our student loan options to help you compare the cost of our college loans with other lenders.
What is student loan interest?
When you borrow money to pay for college or graduate school, you won’t just be paying back the amount you borrowed. There’s also a cost to borrowing that money, and that cost typically includes, among other things: interest. Interest is usually expressed as a percentage of the principal amount borrowed and can be either set at a fixed or variable rate, depending on the type of loan you have. The interest on your college loans can significantly impact the total amount you’ll repay over time. Continue reading as we dig into the types of student loans and define how student loan interest is calculated.
Types of student loans and interest rates
Federal student loans
The U.S. government offers federal student loans, which are often students’ first choice after completing the Free Application for Federal Student Aid (FAFSA®) of their favorable terms and lower interest rates. The common types of federal student loan options include Direct Subsidized Loans, Direct Unsubsidized Loans, and Direct PLUS Loans.
The interest rates for federal loans are set by the federal government and are based on two factors: the loan type and the first disbursement date of the loan. For most federal loans, the interest rates are fixed, meaning they won’t change over the life of the loan, which can make budgeting for repayment more predictable.
Private student loans
Private entities like banks, credit unions, and online lenders, such as Ascent, offer private student loans. These loans often have higher interest rates than federal loans and may require a credit check. Interest rates for these loans can be fixed or variable, depending on the lender’s policies (more on these concepts below).
How student loan interest is calculated
Fixed and variable rates are the primary ways to calculate student loan interest. Let’s explore the key differences between the two.
Fixed-rate student loans have an interest rate that remains the same for the life of the loan. This means your monthly payment will also stay the same, making it easier to budget for your loan payments. The interest on a fixed-rate loan is calculated by multiplying the loan’s interest rate by the total principal amount.
Variable-rate student loans have an interest rate that can change over time based on market conditions. This means your monthly payment can also vary, making budgeting more challenging. Remember that variable-rate loans can offer lower interest rates initially, which can be beneficial if you plan to repay your loan quickly.
Subsidized vs. unsubsidized loans
Understanding the difference between subsidized vs. unsubsidized loans is crucial when considering your future repayment plans. Subsidized loans are need-based loans where the government pays the interest while you’re in school or during deferment periods. On the other hand, unsubsidized loans accrue interest when the loan is disbursed, and the borrower is responsible for paying all the interest.
Understanding capitalized interest
Capitalized interest is a term you’ll often encounter when discussing how student loan interest works. But what does it mean? Capitalization is when your unpaid interest is added to the principal amount of your loan. Capitalization can happen at the end of your grace period, deferment, or forbearance, or if you choose to leave an income-driven repayment plan or consolidate your loans.
When interest is capitalized, it increases the principal amount you owe. You may end up paying interest on a larger amount. This can significantly increase the total cost of your loan. It’s important to note that the frequency of capitalization can vary based on the type of loan and the terms of your loan agreement. For instance, interest on private student loans may be capitalized more often than on federal student loans, sometimes as often as monthly.
When student loan interest starts
A common question among borrowers is whether student loans have interest that starts accruing immediately. The answer depends on the type of loan. For federal unsubsidized loans and most private student loans, interest starts accruing as soon as the loan is disbursed. This means your loan balance grows while you’re in school and during your grace period.
However, if you have a federal subsidized loan, the government pays the interest on your loan while you’re in school at least half-time, during your grace period, and during any periods of deferment. During this time, your loan balance will not increase. But remember, once you enter repayment or if your loan enters a forbearance period, interest will begin to accrue.
The importance of understanding student loan terms
Understanding the terms and mechanics of student loan interest is essential in planning your financial future. It’s not just about knowing your interest rate. You should also know when the interest starts accruing, how it’s capitalized, and how payments are allocated.
Staying on top of these details may help you save money and pay off your debt faster. Knowing when interest accrues allows you to take advantage of opportunities to reduce overall interest. Additionally, strategically directing payments toward the principal helps you progress on your debt and may save you money in the long run.
So, take the time to understand the terms of your student loans. This knowledge may empower you to make smart financial choices and take control of your repayment journey. With careful planning and strategic actions, you can confidently navigate your student loans and work toward a brighter financial future.
Learn more with Ascent
At Ascent, we’re committed to helping students navigate the world of student loans. From the basics of student loans to repayment strategies, we’ve got the financial wellness resources you need to help make informed decisions about your future.
Can student loans be used for other expenses besides tuition?
Yes, you can use student loans for other expenses related to your education. “Other expenses” may include books, supplies, meal plans, room and board, transportation, and technology expenses like a computer. However, remember that all these expenses must be repaid with interest. It’s best to only borrow what you need.
How long does it take to pay off student loans?
The time it takes to pay off student loans can vary depending on your repayment plan, the amount you owe, and how much you can afford to pay each month. The standard repayment plan for federal student loans is ten years, but income-driven repayment plans can extend the repayment period to 20 or 25 years. For private student loans, the repayment period can range from 5 to 20 years or more.