With student loans, borrowers pay a specific amount of money toward the principal of their loan each month, but they’re also charged an extra percentage in the form of interest. In most cases, student loans charge simple interest, which means that you don’t pay interest on your unpaid interest. Here’s what to know about simple 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 amount and don’t accrue interest on your unpaid interest. Because of this, you pay less interest over the life of your loan. With each month’s payment, you pay the full amount of interest you owe for that month.
With compound interest, on the other hand, you’ll inevitably pay more interest over time. This is due to the fact that compound interest allows the lender to charge interest on your balance and on unpaid interest that accrues over time.
Do federal student loans ever compound interest?
There are some scenarios where your interest compounds on federal student loans. This is most common during student loan deferment periods where interest accrues on the amount you borrowed while you’re temporarily not making payments. This means that once the deferment period is over, you’ll typically owe more money than you did when you originally requested the pause on loan payments, since that unpaid interest is added to your loan balance.
Unpaid interest can also accrue any time you’re repaying your loans under an income-driven repayment plan and your monthly payment is less than the amount of interest that accrues each month. When unpaid interest is added to your balances owed in either of these situations, the act of increasing the loan balance is referred to as capitalization.
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, though the portion of your payment that goes toward interest decreases with each successive payment. You can see how this works by using a student loan calculator.
How simple interest is calculated
To calculate simple interest, you’ll 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 come up with the daily interest rate for your loan, you’ll divide your loan’s interest rate by the number of days in the year.
Say you have a $10,000 loan with an interest rate of 5.28 percent. 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 how much you’ll pay in interest during your first month of repayment. As you pay off your principal, that monthly interest charge will shrink. For example, once you whittle down your principal to $5,000, here’s what the formula looks like:
- 0.0528 / 365 = 0.000144.
- 0.000144 x $5,000 = $0.72.
- $0.72 x 30 = $21.60.
How compound interest is calculated
While rare, some private student loans use a daily compound interest formula. In this method, accrued interest is continually added to your balance. In the above example, the daily interest charge at the beginning of your repayment period, $1.44, would be added to your balance on day one. The next day, you’d find your daily interest charge by multiplying your daily interest rate by $10,001.44, and so on. Here’s what that 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 the increase to your balance might be only a few dollars, the growth can be exponential the longer your interest goes unpaid.
The bottom line
If you owe money on student loans or plan on borrowing for higher education in the future, you’ll most likely be charged simple interest on your loan balances. This makes it considerably easier to pay down your student debt faster and avoid a situation where your loan balance is climbing faster than you can pay it off. If you want to avoid paying more interest than necessary, you can always make extra payments on your loans and request that they go toward the principal.