How does student loan interest work?

What Every Borrower Should Know About Interest

When you know how student loan interest works, you are prepared to make the best choices about your finances. Here are the major concepts that you need to know about interest on student loans:

The basics of how student loan interest works

Interest is a percentage of the amount borrowed, which is also known as the principal. 

The higher your interest rate, the more money you end up paying to the lender on top of the amount borrowed. Higher interest rates are usually offered to less desirable borrowers — those with a poor credit history, low income, or other factors — while lower interest rates are reserved for borrowers with excellent financial credentials.

Student loan interest can be influenced by multiple factors, most notably whether your loans are federal or private. Here’s a detailed breakdown of everything you need to know when it comes to student loan interest.

How does student loan interest work for federal loans?

Interest on federal student loans works in two different ways, depending on the type of loan you have. 

On unsubsidized loans, the lender starts charging interest while you’re still in school, even though your payments won’t be due until you graduate or drop below part-time status. The interest that accrues during this time will be added to the principal balance once the grace period is over.

This process, also known as capitalization, will increase the principal, monthly payments, and total amount of interest you pay over the life of the loan. This is why experts recommend trying to make payments while you’re in school and to limit how much you borrow overall.

Capitalization: When accrued interest on a loan is added to the principal (the original amount borrowed), so that the interest begins to accumulate on top of the accrued interest. 

Federal subsidized loans, including Direct Subsidized Loans and Perkins Loans, charge interest while you’re in school but the government pays it — that’s the subsidizing part. They also cover the six-month grace period that follows after you graduate or drop below part-time status. 

Federal loans have different interest rates depending on the type of loan, but the rates do not vary based on the borrower. The government does not use factors like credit score, potential future income, or GPA to determine the interest rate.

The federal government may also raise or lower the interest rate from year to year, depending on market conditions. For example, the government decreased rates from 4.529% to 2.750% in response to the Covid-19 pandemic.

Perhaps you’ll make use of a loan deferment program at some point. The federal government has several different types of deferment programs, during which time interest may or may not accrue. This is based on the type of deferment and the type of loan. If you’re considering a deferment, ask the loan servicer how interest is treated during the deferment.

How does student loan interest work for private loans?

Private loans come with a wide range of interest rates, and lenders will use a few different factors to determine the actual terms offered to a borrower. This can include credit score, income, current major, future projected earnings, and whether a parent cosigns on your student loans.

Private loans will either have a fixed interest rate or a variable rate. Fixed-rate loans have the same interest rate over the life of the loan, while the rate on variable-rate loans will change with the market rate. The interest rate on variable-rate loans may change anywhere from monthly to yearly, depending on the lender. 

Fixed rate: When the interest rate on the loan stays the same over the life of the loan.

Variable rate: When the interest rate on your loan changes with market rates, anywhere from monthly to yearly depending on the terms of the loan.

Many private loans offer a six-month grace period after graduation, during which time interest will also accrue. It may or may not be capitalized, depending on the lender.

How to decrease your interest rate

When you first start repaying your student loans, the bulk of your monthly payment will go toward interest and not the principal. This will decrease over time, and the majority of your payments will go toward the principal by the end of the term. 

If you’re looking to lower your interest rate, here are the best options:

Sign up for automatic payments

Almost every lender provides an interest rate discount when you enroll in automatic payments. Funding U lowers the rate by 0.50%, while the federal government provides a 0.25% discount. Most other private lenders have a 0.25% discount as well. 

Automatic payments have the added benefit of making it easier to be consistent with your payments. As long as you have enough money in the bank account linked to your student loan account, you’re unlikely to ever be late on a payment.

It’s easy to sign up and cancel automatic payments any time you want. You can choose to only pay the minimum or pay extra.

Refinance your loans

Borrowers with strong credit can also refinance their student loans to get a lower interest rate. Refinancing a federal student loan converts it into a private student loan, which means you forfeit any extra benefits like income-based repayment options and extended deferment and forbearance.

If you already have private student loans, refinancing has few drawbacks. You can refinance your student loans as often as you want to take advantage of low interest rates, an improvement in your credit score or a bump in your income.

Understand your own interest rate

If you don’t already know the interest rate on your loans, take a few minutes to look that information up. Knowing the rate could change how you approach your student loans and whether or not you refinance them. 

No cosigner student loans from Funding U

At Funding U, we make no cosigner student loans directly to college students. We don’t look at your parents’ credit; we look at you, your academic progress, and your financial plan. Apply online.Check out our latest blog posts for tips and useful info about managing money in college, navigating the job market, and more.

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