How Student Loan Interest Works for Dummies

Maybe it is just me, but when I was 18 and set to go to college the furthest thing on my mind was student loans.

how student loan interest works graphic

Moving into the dorms, hanging out with friends, and of course, getting a great education, were the primary focuses from age 18 to 22. But then something changed…

Six months after graduation, a portion of my hard-earned dollars as a teacher started going to student loan payments. And admittedly so, I had no clue how student loan interest (or interest in general) worked.

I found myself asking this question,  how does student loan interest work?

Understanding Student Loan Interest 101

To first understand how student loan interest works, it is worth rewinding a little and going back to personal finance 101.

While it is just now becoming more common for states to mandate a personal finance class in high school, for most student loan borrowers, interest was simply a concept that was taught by parents or self-learned.

There are two ways to earn interest:

  1. When borrowing money – a fee or interest charge is administered by the lender for allowing you to borrow the money.
  2. When lending your money – you earn a percentage based on the amount of money you contributed to say a savings account or investment.

Interest can obviously work against or for you, but when it comes to student loan interest it is against you.

Simply put, interest is the extra money you pay (or earn if saving) for taking out a loan.

That amount of extra money is based on what is called your principal, or how much you took out/still owe.

While some of this might seem rudimentary, it is a simple concept that is often overlooked and under taught. The quickest way to find your student loan interest is to use a student loan calculator.

How is student loan interest calculated?

Student loans have two types of interest:

  1. Subsidized – meaning the interest starts to accrue after graduation
  2. Unsubsidized – meaning the interest starts to accrue as soon as the loan is taken out.

Subsidized student loans are the most common with undergraduate student loans as the government recognizes that while in school, most students are not making an income, therefore the interest is covered.

As for the unsubsidized loans, interest starts to build the minute loans are disbursed. For most student loans, interest gathers daily, but some may compound monthly.

Daily Compounding Student Loan Interest

The big difference between how student loan interest works and how traditional forms of interest work is that student loan interest is typically compounded daily.

In other words, the interest rate is divided by 365 days and then that number is charged daily based on the remaining principal balance.

For example, let’s take the average student loan balance and rate from 2016. Graduates from 2016 on average had a student loan balance of approximately $36,000 with an average interest rate of 4.5%.

In this scenario, 4.5% divided by 365 is .012%. Using the principal balance of $36,000, .012% of $36,000 equates to $4.32 per day, or about $130 per month in interest alone.

For unsubsidized student loans, compounding daily interest quickly escalates since students are not repaying while in school. This is why students can see their original loan balance increase as interest is accrued daily while still in school.

Now that you understand how student loan interest works, what should you do to beat it?

How to minimize student loan interest:

The quickest way to minimize student loan interest is to pay the principal balance quicker. While refinancing student loans to get a better interest rate isn’t a bad idea, the real trick it pay off student loans as fast as possible to knock down the principal balance.

Since the daily compounding rate is based on the remaining principal balance when it comes to student loans,  the quicker you pay down your student loan principal, the less impact interest has.

To pay off student loans quicker consider doing the following:

  1. Using cash windfall payments from tax returns
  2. Use side hustle money to pay off student loans
  3. Consider refinancing, just be aware of the pros and cons of refinancing student loans.

For a complete student loan payoff guide, use this link to get my free PDF. At this point you now understand how student loan interest works, but here is our personal story as to how it can make an impact on your finances.

Our story on how student loan interest works.

I recently looked at our student loan repayment history on “My Great Lakes”  and felt compelled to share the photo below.

how student loan interest works

I quickly found out/realized that not a single dollar from the monthly minimum payments was doing anything to bring down the principal amount (what we owe and what the interest amount is derived from).

The $390.45 payment in the first column is the minimum, followed by the $0.00 which went towards the principal. In the photo above, the third column is the amount that went towards the interest and the last column is how much we currently owe on Lauren’s undergraduate loans.

Not a single payment since went towards the principal amount. However, what many borrowers fail to recognize is that all the interest that accrues capitalizes annually.

In other words, the back interest was added to the principal amount in March 2017, hence why the principal balance jumped $2854.27.

Pay off student loans fast.

Paying off your student loan principal as fast as possible will save you money in the long run. While waiting for things like public service loan forgiveness get’s riskier by the day because of interest, here several reasons  why some people don’t take student loans seriously:

  1. Many don’t understand how student loan interest is calculated (Now you do)
  2. Focusing on paying off student loans can sometimes require lifestyle adjustments. Eating out less, less travel, less social events just doesn’t seem so fun when you are in your 20’s.
  3. There is a common misconception among current college students that student loans will just be “forgiven” (just check out this survey).
  4. Everyone has student loans so it is widely accepted that it is just OK to have them.

However, addressing student loans while young isn’t such a bad idea. The amount of owed student loans is now over 1.6 trillion, but in 2003 = Quarter Trillion; 2013 = 1 Trillion; 2018 = 1.5 Trillion.

Four Real Life Reasons to Pay Off Student Loans:

A simple Google search of “Student Loan Payments” will net you 3.6 million results in .62 seconds (If only they could be repaid back that quickly).

While there is plenty of info as to how to pay off student loans, here is why you should consider paying them off now that you understand how student loan interest works:

  1. Daily Compounding Interest. Considered “Good Debt,” because student loans sometimes have a low-interest rate, but the interest is compounded daily.
  2. Savings Rates are at an all-time low. In 2016-2017 Americans were saving an average of 3% of their income. Most retirement planners recommend at least 15%. Student loan payments and expensive housing are two reasons why more people are not saving.
  3. Health Reasons. The #1 cause of death in the United States is still heart disease. Stress is one of the leading causes of heart disease, and the most common reason for stress is money worries according to an APA study.
  4. Better relationships. Citibank found 57% of divorced couples believe that money caused the deterioration of marriages. Millennials are marrying with student loan debt.

My takeaway on how student loan interest works.

The screenshot above from just one of our student loan accounts is why we focus on paying off our student loan debts.

In 2016, we paid well over $45,000 towards my wife’s student loans, only to have $17,000 in back interest capitalize. We saw our student loan principal jump $17,000.

As I alluded to earlier, Interest capitalization is when unpaid interest (because we started on income-based repayment) is added to the principal amount owed. A simple understanding of how student loan interest works made us realize that paying the minimums and watching the principal amount increase each year wasn’t going to work in our favor.

Here are some photos below of what we owed in 2017:

understanding how student loan interest works

Now, after focusing on paying off student loans we have successfully been able to get ahead of our interest by driving down the principal. While this wasn’t always easy, it simply started with understanding how student loan interest worked.

Once we understood student loan interest wasn’t in our favor, we made short term sacrifices which allowed us to pay off $150,000 in under 36 months. So while the intentions of our personal anecdote are only to offer perspective when it comes to student loan interest there are two takeaways I would recommend:

  1. Go see how much interest you’re paying towards student loans monthly.
  2. Pay your principal faster, even if it is just $100 a month.