08 Nov 2017

How Student Loan Interest Actually Works

How Student Loan Interest Actually Works

We've all heard the numbers on student loans, right? Today, the average student loan balance for Americans is over $30,000, and the national student loan debt balance is a staggering $1.4 trillion that keeps growing every day.

But surprisingly, the most important number that many people with student loans aren't even aware of is their student loan interest rate. Typically, borrowers tend to focus on their student loan total rather than the interest rate that's attached to it.

As a personal finance blogger, one of the most common questions that I ask when talking to readers about their student loans is: "What's your current student loan interest rate?"

More than half of the time, readers don’t actually know their rate without having to pull out their loan paperwork!

Understanding what type and amount of interest your student loans carry, and more importantly how it impacts your overall student loan repayment cost, is essential if you're looking to get out of debt quickly.

Here are the most important questions you need to ask about your student loan interest:

How is student loan interest calculated?

Federal student loan interest isn't calculated the same way that interest is calculated on a car loan or a credit card. Those types of debt are typically calculated with compound interest, while student loans use simplified daily interest.

Here's how it works:

Simplified Daily Interest Formula

Simplified daily interest is the type of interest associated with Federal student loans and most private student loans. It's a fairly easy two-part formula.

Daily interest amount = (Current Principal Balance x Interest Rate) ÷ 365.25

Monthly interest amount = (Daily Interest Amount x number of days in the month)

Here's an example of how simplified daily interest works on a $40,000 student loan balance with 6.8% interest:

Daily interest amount = ($40,000 x .068%) ÷ 365.25 = $7.4469

Monthly interest amount = ($7.4469 x 30) = $223.40

So in the example above, a borrower with $40,000 of student loan debt at 6.8% interest will end up paying $223.40 in interest per month (which will vary slightly based on how many days are in the current month).

Is my loan interest rate fixed or variable?

Depending on the type of student loans you have, your interest rate might be either a fixed rate or a variable rate.

Fixed:

If you have Federal student loans in the form of Direct Subsidized Loans, Direct Unsubsidized Loans, or Parent Plus loans, you have a fixed rate that is set by Congress.

If you attended undergraduate or graduate school before July 1st, 2017, go to the Department of Education website here to see interest rate changes over the last decade.

Here are the new Federal interest rates as of July 1st, 2017 for anyone planning to attend graduate school or attain a professional degree:

Direct Unsubsidized Loans: 6%

Parent Plus Loans: 7%

For the life of your loan, these interest rates will not change regardless of interest rate increases or decreases by the Fed.

Variable:

If you hold private student loans or are planning on refinancing in the near future, there is a chance that you will receive a variable interest rate depending on the type of loan you choose.

These are a popular product from banks and student loan lenders because they often have very attractive initial rates compared with fixed interest rates.

However, it's important to understand that variable rates will ebb and flow based on a metric called the "1 month LIBOR average." While variable rates have been low lately due to the current low-interest environment controlled by the Fed, they went up to as high as 10.6% in 1989.

Just because rates have stayed low in recent years, you can never use past indicators to predict future rates. If interest rates were to rise sharply, your monthly loan payment would increase with it. It's important to think long term with your loans and consider if you could actually afford a drastic increase in your monthly payment.

What happens when you pay extra toward your student loans?

When you make your student loan payment every month, the money is applied to your loan in the following order:

  1. Any outstanding fees
  2. Interest
  3. Principal loan amount

This does, unfortunately, mean that any extra payments you make toward your loans won't completely be applied to the principal balance. But don't let that discourage you from paying more than you need to every month!

Even a small amount like $100 or $200 will make a massive dent in your loans, and ultimately save you thousands of dollars over the course of the entire loan (depending on your loan terms).

There are two different strategies that you can use to pay your loans off faster:

The Snowball Method

This method is extremely popular because it yields "quick wins" that tend to motivate people who are hoping to get out of debt sooner.

With the snowball method, you would categorize your loans by the lowest principal amount (regardless of the interest rate), and then attack the smallest loan first.

Once the smallest loan is gone, you take the money that you no longer have to pay toward it and add it to your extra payment amount. Then, you tackle the smallest remaining loan again and repeat the process until all your loans are paid in full.

The Avalanche Method

While this method isn't nearly as popular as the snowball method, it's actually more effective from a time standpoint.

With the avalanche method, you will categorize your loans by the interest rate from largest to smallest. Then, you apply your extra payment toward the loan with the highest interest rate, pay it off, and move down the list to the next loan.

This method doesn't "feel" as fast, but it actually accelerates your loan payoff and reduces the amount that you pay toward interest. This is my preferred debt payoff strategy because it saves you more money in the end.

After talking to thousands of student loan borrowers, I've found that the ones who were the most informed about their loan interest rates and how they work tend to be more aggressive with their debt-payoff goals.

In addition, understanding your loans fully will help to make them seem less overwhelming and ultimately make the process of paying them off less stressful for you.

-- Bobby Hoyt is a former high school teacher who paid off $40,000 of student loan debt in a year and a half. He now runs the personal finance site MillennialMoneyMan.com full-time, and has been seen on CNBC, Forbes, Business Insider, Reuters, Marketwatch, and many other major publications.

The opinions and advice expressed in this article are those of the author and do not necessarily reflect those held by the American Psychology Association (APA).

Did you find this article useful?

1 0

Leave a Reply

Your email address will not be published. Required fields are marked *