With student loans, borrowers pay a specific amount of money each month on the principal of their loan, but they also have to pay an additional percentage in the form of interest. In most cases, student loans charge straightforward interest, which means you don’t pay interest on your unpaid interest. Here’s what you need to know about simple interest versus compound interest and how to calculate each one.
Do student loans have compound or simple interest?
All federal student loans and most private student loans charge simple interest instead of compound interest.
With simple interest, you pay interest only on your principal and do not earn interest on your unpaid interest. As a result, you pay less interest over the life of your loan. With each monthly payment, you pay the full amount of interest you owe for that month.
With compound interest, on the other hand, you will inevitably pay more interest over time. This is because compound interest allows the lender to charge interest on your balance and any unpaid interest that accumulates over time.
Do Federal Student Loans Ever Compound Interest?
There are certain scenarios where your interest consists of federal student loans. This is most common during periods of deferment of student loans when interest is accruing on the amount you borrow while you are temporarily not making any payments. This means that after the deferral period is over, you will usually owe more money than when you originally requested the suspension of loan payments, as this unpaid interest is added to your loan balance.
Unpaid interest can also accumulate whenever you pay off your loans under an income-based repayment plan and your monthly payment is less than the amount of interest that accumulates each month. When overdue interest is added to your owed balances in either of these situations, increasing the loan balance is called compounding.
How student loan interest works
Student loan interest is calculated as a percentage of your principal balance. Interest is included in every monthly payment you make. If you have a fixed interest rate, your monthly payment will stay the same each month, although the interest portion of your payment decreases with each successive payment. You can see how it works by using a student loan calculator.
How simple interest is calculated
To calculate simple interest, you multiply your outstanding principal balance by the daily interest rate applied to your loan, then multiply that result by the number of days in your payment cycle. To calculate the daily interest rate on your loan, you will divide the interest rate on your loan by the number of days in the year.
Suppose you have a loan of $ 10,000 with an interest rate of 5.28%. Here’s how you would calculate your interest payment using simple interest:
- Find your daily interest rate: 0.0528 / 365 = 0.000144.
- Multiply your daily interest rate by your principal balance: 0.000144 x $ 10,000 = $ 1.44.
- Multiply your daily interest charge by the number of days in your payment cycle: $ 1.44 x 30 = $ 43.20.
This is the amount you will pay in interest during your first month of repayment. As you pay off your principal, those monthly interest charges go down. For example, once you’ve reduced your principal to $ 5,000, this is what the formula looks like:
- 0.0528 / 365 = 0.000144.
- 0.000144 x $ 5,000 = $ 0.72.
- $ 0.72 x 30 = $ 21.60.
How is compound interest calculated
Although rare, some private student loans use a daily compound interest formula. In this method, accrued interest is continually added to your balance. In the example above, the daily interest charge at the start of your repayment period, $ 1.44, would be added to your balance on the first day. The next day, you will find your daily interest charge by multiplying your daily interest rate by $ 10,001.44, and so on. This is what it looks like:
- Day 1: 0.000144 x $ 10,000 = $ 1.44.
- Day 2: 0.000144 x $ 10,001.44 = $ 1.4402.
- Day 3: 0.000144 x $ 10,002.88 = $ 1.4404.
- Day 4: 0.000144 x $ 10,004.32 = $ 1.4406.
While your balance increase may only be a few dollars, the growth can be exponential the longer your interest remains unpaid.
The bottom line
If you owe money on student loans or plan to borrow for higher education in the future, you will likely have to pay simple interest on your loan balances. This makes it much easier to pay off your student debt faster and avoid a situation where your loan balance grows faster than you can pay it off. If you want to avoid paying more interest than you need to, you can always make additional payments on your loans and request that they be paid out of the principal.