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Most student loans come with simple interest, meaning you generally only pay interest on the original amount you borrowed. On the other hand, student loans with compound interest require you to pay interest on the principal balance and unpaid interest. As a result, compound-interest student loans have higher total borrowing costs than loans with simple interest.
Learning how interest on your student loan works can help you save money and kick student debt to the curb faster.
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 interest you owe for that month.
With compound interest, on the other hand, you’ll inevitably pay more interest over time. This is because 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 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 because 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 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:
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:
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:
While the increase to your balance might be only a few dollars, the growth can be exponential the longer your interest goes unpaid.
When does student loan interest start accruing?
Interest starts accruing on your student loans when the lender disburses your loan. You may not need to pay your student loans while in school, but interest will accrue.
If you have federal subsidized student loans, the federal government pays any interest that accrues while you’re in school and in future deferment periods. If you don’t have this type of loan, the lender or loan servicer will add all the interest that accrues during your deferment to your student loan balance.
If you want to avoid having your interest capitalized, you can make interest-only payments while you’re in school, in your grace period or in a period of deferment.
The bottom line
When you take out a student loan, nine times out of 10, it’ll come with simple interest. All federal student loans have simple interest, while most private lenders charge simple interest. To avoid paying unpaid interest, consider making interest-only payments during your loan’s grace or deferment period. If you have a student loan with compound interest, consider refinancing to a loan with simple interest to save money.
Frequently asked questions
When it comes to borrowing money, simple interest is better than compound interest because you’ll pay less interest over the life of the loan.
If you have a student loan with compound interest, you can switch it out by refinancing with a lender that offers simple-interest student loans.
A student loan with compound interest leads to higher overall costs than one with simple interest.