Looking into student loans to pay for college or graduate school? Before you take on debt, it’s important to understand how the interest on student loans work, so you can make smart decisions before you borrow and when it comes time to repay the debt.
Understanding how student loan interest works
When you take out a student loan, the lender charges interest as a fee for borrowing the money. Interest on student loans isn’t a flat fee. Instead, interest on student loans is expressed as a percentage of the unpaid loan amount. Right now, federal direct unsubsidized loans for undergraduates carry a 4.45% annual interest rate (but they’re about to go up for the 2018-19 school year). That means the lender charges 4.45% of the unpaid loan balance per year.
When interest on a student loan goes unpaid, the balance of the loan grows over time. For example, during college many students “defer” student loan payments. In general, during deferment, the bank continues to charge interest, so the balance grows over time. A student who borrows $5,000 at a 4.45% interest rate at the start of his freshman year of college will owe $5,974 four years later when he starts making payments. Generally, any unpaid interest is added to the principal balance once the loan enters the repayment period.
Even though interest rates on student loans are expressed as an annualized interest rate (such as 4.45% per year), interest on federal student loans is determined by a daily interest rate. A 4.45% annual interest rate translates to a 0.0122% daily interest rate.
Once you start making standard monthly payments on the loan, the balance of the loan and dollar amount of interest being charged each day drops. For example, on a 10-year repayment plan, the $5,000 loan that grew to $5,974 loan from the previous example will have a $61.77 monthly payment.
After making the first payment, the balance will fall by $39.62 to $5,934 — the other $22.15 goes toward paying interest. By contrast, with the last payment, $61.27 goes toward balance reduction, and just $0.23 goes towards paying interest.
Many people have heard stories of student loan borrowers who have faithfully made regular payments for decades but have barely made a dent in their balance or owe more money today than when they graduated from college. This doesn’t happen when borrowers make payments based on standard repayment plans. However, it can happen when federal loan borrowers opt for income-driven repayment plans. Under these plans, the monthly payment is based on a person’s income, not on a repayment schedule. That means that the required monthly payment could be less than the amount of interest that the lender charges on the loan. In that case, the balance of the loan grows over time, and the amount of interest charged grows, too.
Variable vs. fixed interest rates
All federal student loans disbursed since July 1, 2006, have fixed interest rates, meaning the interest rate will never change. By contrast, some private lenders offer variable-rate loans. Variable-rate loans are loans where the interest rate may change over time. In general, variable interest rates are set based on an index rate such as the LIBOR (London Interbank Offered Rates). When the LIBOR increases, the variable interest rate on a student loan increases. When it decreases, the interest rate on a student loan decreases. The interest rate on a variable-rate loan could change as often as once a month.
As the interest rate on a variable-rate loan changes, the minimum monthly payment changes, too. A higher interest rate will mean a higher monthly payment, and a lower interest rate will mean a lower monthly payment.
Some variable-rate loans will have maximum interest rates. That means, no matter how high the index rate goes, the lender will not charge more than the maximum rate.
The primary advantage of fixed-rate loans are that borrowers will know exactly how much they owe each month, which makes it easy to budget for. However, most private lenders set higher interest rates for fixed-rate student loans compared with variable-rate loans. That means that borrowers could end up paying more in interest over time.
The lower starting interest rates mean that some people may save money by opting for a variable-rate loan. But variable-rate student loans are riskier than fixed-rate loans. The changing interest rates could mean that borrowers have to make large monthly payments and pay more in interest over the life of a loan.
When should borrowers choose a fixed-rate student loan?
No wiggle room in budget: Fixed-rate student loans are an ideal choice if you don’t have a ton of wiggle room in your budget. You may pay a bit more — but you might not — and you don’t have to worry about your monthly payment increasing.
Long repayment periods: Fixed-rate loans also tend to make sense if your repayment plan will last several years. By contrast, variable rate loans are riskier when you face longer repayment periods. Longer repayments mean that you’ll face a higher risk that the rate will increase significantly from where you first took out the loan.
Small rate difference between fixed- and variable-rate loans: Variable-rate loans often have lower prices, but you get that lower price by taking on more risk. If the interest rate you’ll pay on a fixed-rate loan is just a tiny bit more than the interest rate on a variable-rate loan, the peace of mind is probably well worth the financial cost. Plus, if interest rates fall, you may be able to refinance to a lower, fixed rate in the future.
When should borrowers choose variable-rate student loans?
Expect rapid loan payoff: Borrowers who plan to aggressively pay back loans (and cut years off of standard repayment plans) can take advantage of lower interest rates in the early years of the loan. Even if interest rates rise over time, people who aggressively pay back loans in the early years will save enough in interest to compensate for the higher rate in the later years.
Rate difference between fixed- and variable-rate loans: Most of the time, variable-rate loans are less than 1% cheaper than fixed-rate loans. This offers some savings. But depending on your borrower qualifications (credit score, debt-to-income ratio, etc.), you may qualify for a much better variable-rate loan. If you personally qualify for a much lower rate on a variable rate loan (compared with a similar fixed-rate loan), you can expect to save a lot of cash over the life of a loan, even when student loan interest rates start to rise.
Federal student loan interest rates
Congress sets interest rates on federal student loans. Once you borrow the money, the interest rate on the loan will not change because federal student loans have fixed interest rates, but not all federal student loans have the same interest rates. For example, direct unsubsidized and subsidized loans for undergraduates carry a 4.45% interest rate for the 2017-18 school year. The same loan for graduate or professional students is 6%. PLUS loans, which are available for parents and graduate students, have a 7% interest rate. For federal student loans disbursed between July 1, 2018 and June 30, 2019, rates are as follows: 5% for undergraduate loans, 6.6% for graduate and professional unsubsidized loans and 7.6% for PLUS loans borrowed by parents or graduate and professional students.
How does interest work during deferment?
Many students defer payment on their student loans while they are studying or for select other reasons, such as unemployment or active-duty military service, if their loans offer such flexibility (some private loans and all federal loans do).
During deferment and the grace period following graduation, you will not make payments on your student loans, but interest continues to accrue on the loan. Interest that accrues during deferment is added to the balance of the loan, so your principal loan balance grows during deferment.
However, the U.S. Department of Education helps reduce the burden of interest by paying interest on subsidized loans while the borrower is enrolled in school at least halftime, during deferment and during the grace period that follows graduation. Subsidized loans include direct subsidized loans, federal Perkins loans and the subsidized portions of direct consolidation loans and FFEL consolidation loans.
It’s important to note that deferment is not the same as forbearance. Forbearance is a period of reduced or suspended payments a lender may grant to a borrower going through financial hardship. During forbearance, interest continues to accumulate and will capitalize (be added to the principal balance).
Current interest rates and fees on federal student loans
The table below shows the interest rates and fees on federal student loans for the 2018-19 school year. It’s important to note that some loans have a loan fee. These fees are a percentage of the principal balance, taken from the disbursement and paid to the bank. For example, a $5,000 loan will actually be a $4,946.70 disbursement to you (assuming the 1.066% loan fee).
Federal loan type
Does interest accrue during deferment?
4.45% (for loans disbursed between July 1, 2017 and June 30, 2018)
Graduate or professional students
Weighted average interest rate of all loans being consolidated, rounded up to the nearest one-eighth of one percent.
Generally yes. The subsidized portions of the loan do not accrue interest during deferment.
Parents, graduate students and professional students
Private student loan interest rates
Private student loans can be a double-edged sword for students and their parents. The private student loan marketplace allows a greater level of borrowing, and some people find better interest rates in the private loan marketplace. However, private student loans generally do not offer the safeguards of federal student loans.
For example, many private loans don’t offer forbearance or deferment (except in-school deferment), and they may have very high student loan interest rates. Unlike federal student loans, most private student loans don’t have income-driven repayment plans, and the interest rates on private student loans aren’t set by legislation. Instead, interest rates on private loans are determined by a variety of factors:
- Your credit score (or the score of a cosigner)
- Your income (or the income of a cosigner)
- Employment status
- The length of repayment
- Fixed- or variable-rate terms
- Rates charged by other lenders
Many private lenders require a cosigner (someone who promises to make payments if you can’t) if you don’t have a high enough income or credit score to qualify for the loan.
Interest rates on private student loans have a much greater variety than federal student loans. For example, some student loan refinancing companies offer interest rates as low as 2.57%. However, some lenders charge interest rates that exceed credit card interest rates.
Borrowers who are considering private student loans should research the costs and have a plan to make the required monthly payment once they graduate.
Student loan interest rate vs. APR
When it comes to student loan borrowing, borrowers should understand both the interest rate and the APR (annualized percentage rate) on a loan. The Federal Truth in Lending Act requires lenders to disclose a loan’s APR. APR measures the annualized cost of all finance charges (including interest and transaction fees) if you make all your payments on time. By contrast, the interest rate on a loan is simply the annual cost of borrowing the money, and does not include other fees.
When you pay off student loans early, you will reduce the total interest you pay on the loan. However, finance charges (such as loan fees or origination fees) are not reduced by paying off the loan early.
Lowering your student loan rates
When it comes to any type of borrowing, paying less in interest means you’ll have more money to put elsewhere. Student loan borrowers should consider methods for reducing the interest rate on their loan, and methods to pay less interest overall. These are just a few options to consider.
Lowering your student loan interest rates
Fill out FAFSA: If you’re a traditional student (generally under 24 years old with limited work/life experience), federal student loans likely offer the lowest possible interest rates on student loans. To qualify for federal aid, you and your parents must fill out the FAFSA (Free Application for Federal Student Aid). The FAFSA may also be required for merit-based aid at your university.
Get a cosigner: Borrowers in the private marketplace may find that a cosigner helps them qualify for a reduced rate. Its common for grandparents or parents to cosign private student loans, but cosigners must exercise caution. If a borrower can’t make their monthly payments, the cosigner has to step up and make the payments, otherwise both borrowers’ credit scores will suffer from the impact of missed payments.
Refinance: Following graduation, borrowers (especially those with high incomes or good credit scores) may be able to reduce their student loan interest rates by refinancing with private loans. However, borrowers must be careful when refinancing. Private lenders generally do not offer income-driven repayment plans or other safeguards that can help borrowers who experience unemployment, underemployment or low incomes. Plus, debts that are refinanced with private lenders will not qualify for federal student loan forgiveness programs.
Enroll in automatic payments: Many private lenders offer borrowers a rate discount when the borrower sets up automatic monthly payments.
Reducing total interest paid
Reducing interest rates aren’t the only way to free up cash. Borrowers may also use other methods to reduce the total amount of interest they put toward loans.
Borrow as little as possible: The less you borrow during school, the less interest that will accrue on the loans. Students may be able to minimize borrowing during school by working, applying for scholarships and grants, and using savings. This may sound obvious, but it’s important to point out, because the amount you’re approved to borrow may exceed what you need, resulting in unnecessary debt and, as a result, unnecessary interest payments. Budget carefully and borrow only what you need.
Pay more than the minimum: The more money you put toward your loans each month, the faster you’ll pay them off. Extra principal payments are especially helpful in the early life of the loan when a large portion of the standard payment goes to interest. When you put extra money toward your loan, be sure that the additional payment goes toward repaying the principal. The Consumer Financial Protection Bureau offers guidance on how borrowers can make sure their lender processes their payments correctly.
Combine income-driven repayment with student loan forgiveness: A lot of times, income driven repayment plans reduce monthly payments only to have the loan balance grow over time. However, if you qualify for a student loan forgiveness program, the lower payment is a huge advantage. Not only will you reduce your cash outflow during the repayment phase, once you complete the requirements for loan forgiveness, you may qualify for forgiveness without any incurring tax penalties. (However, some loan forgiveness requires you to pay income taxes on the forgiven amount.) Different loan forgiveness programs have different requirements, so be sure you qualify before planning to use this strategy.
Pay interest during school: Many students are cash-strapped during their studies, but putting money toward interest may go a long way toward keeping loans at a manageable level. Making interest-only payments during college allows students to keep loans at a set level instead of allowing the lender charge interest on interest once the loan enters repayment and unpaid interest is capitalized (added to the principal loan balance).
Refinance to a shorter term: Borrowers who have sufficient cash flow can reduce their total interest payment by refinancing their loans to a shorter term. Sometimes a shorter term means a better interest rate. But, even without a lower rate, a faster repayment means that less money goes to interest overall. For example, a borrower with a $10,000 loan at 3.5% will pay $1,866.21 in interest over the life of a 10-year loan. If that borrower refinances to a five-year loan (also at 3.5%) the total interest is cut in half to just $915.03.