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Updated on Tuesday, January 13, 2015
If you’re a recent college graduate who has never had any debt besides the student loans you graduated with, you might not fully understand how interest works when it comes to your loans.
How payments are applied can be a little confusing to someone who has never had to deal with it before.
If that’s the case for you, then you should read on, as we’re looking at how payments go toward the interest of your loans first, and explaining how you can reduce the interest you’re paying on your student loans.
This information can save you thousands of dollars over the life of your loan if you apply it correctly.
How Are Payments Applied to my Loans?
For most student loans, your payment is going to be applied to interest first, and then to principal. If you have any fees associated with your loans (such as a late fee), then your payment will go toward paying your fees first, then interest, and then principal.
If you’re repaying your loans under an Income-Based Repayment Plan, then your payment will be applied to interest first, then fees, and then the principal.
How Is Interest Calculated?
Interest accrues daily on your student loans, so if you check on your balance a few times throughout the week, you’ll see the amount owed increasing. Student loans use a formula of simplified daily interest, which means interest is only accrued on the principal balance.
Let’s take a look at this in action using an example. Feel free to follow along by plugging in your specific loan numbers.
This is the example we’ll be using: student loan balance of $8,000 at a 6% interest rate on a 10-year term, with a minimum payment of $88.82.
To calculate your daily interest amount, use this formula: (Current Principal Balance x Interest Rate) / 365.25
Using our example: (8,000 x .06) / 365.25 = $1.314168377823409 in interest accrues daily.
If you want the monthly interest amount, use this formula: (Daily Interest Amount x Number of Days in Month)
Using our example: $1.3141 x 30 = $39.42 in interest accrues monthly.
Some student loan providers use the “interest rate factor” instead, which is essentially the same thing – the amount of interest that accrues on your loan.
To calculate the interest rate factor, divide the interest rate of your loan by 365.25.
Using our example: .06 / 365.25 = .0001642710472279261.
The formula for the monthly interest rate using the interest rate factor will yield the same results – (Number of Days Since Last Payment) x (Principal Outstanding Balance) x (Interest Rate Factor).
Using our example: 30 x 8,000 x .0001642710472279261= $39.42 in interest accruing monthly.
What you should take away from this is that of your $88.82 monthly payment, $39.42 is going toward interest. Ouch!
What Can I Do To Lower How Much Interest I’m Paying?
Seeing how much of your payments go toward interest can be painful. By paying extra toward your student loans, you can accelerate your debt payoff date and pay less overall.
This is because every time you make a payment over the minimum amount due, more of your payment is applied toward the principal balance. Remember, when the principal balance goes down, the amount of interest accrued does as well.
We know that a 6% interest rate on our $8,000 loan means $39.42 of interest accrues monthly. However, 6% interest on a $6,000 loan is $29.57. It makes quite a difference!
Let’s take our original example from above. If you simply pay $88.82 for the entire 10 years, you’ll have your loan paid off on time, but you’ll actually end up paying $10,657.97. That’s $2,657.97 more than you signed up for, due to interest!
If you add just $100 more onto your monthly payment so that you’re paying $188.82/month, your loan will be paid off in 4 years, and you’ll have saved $1,619 off your total bill (paying a total of $9,038.97).
Alternatively, if you can’t afford to pay more in one chunk, you can make extra payments when possible, such as paying $20/week, every week, toward your loans.
What Does It Mean When Interest Capitalizes?
It’s important to know what this term means – this is something you only have to be concerned about once, and only if you have unsubsidized loans.
Let’s quickly cover the difference between federally subsidized loans and unsubsidized loans. With federally subsidized loans, the government pays the interest for you while you’re in college. With federally unsubsidized loans, the interest starts accruing as soon as the loan is disbursed to you.
If you don’t make any payments to your unsubsidized loan while you’re in college, then all of the interest accrued while you attended will capitalize when your loan enters repayment status (right after your grace period ends).
If you’re still in college, it’s recommended that you at least try to cover the monthly interest payments while in school. It will save you more money down the road! If you’re in your grace period, there’s no harm in starting to pay early. Take advantage of being able to pay down your interest while you can.
Look At Your Payment Schedule
Most student loan servicers provide you with a payment schedule so that you can see how your loan will be paid off. This might help you visualize and understand exactly where your payments are going.
If you don’t see an option for this, try using a loan calculator.
Continue Paying, Even If You’re Paid Ahead
If you do start paying extra toward your student loans, you might notice that the status of your loans says “paid ahead”.
While that means you’re making great progress, it doesn’t mean you need to stop paying your loans. Interest is still accruing! If you take a break and don’t pay, your hard work will be eaten away by interest.
Read the Fine Print
When it comes to paying any loan back, you should be fully aware of the terms of the loan and how it functions. You’re responsible for paying your loans back according to the terms you agreed to.
It’s extremely important to know how your payments are being applied to your student loans. If you have a different type of student loan and aren’t sure how interest is being calculated (or how your payments are being applied) then call your student loan servicer. Many of them have helpful resources on their website that will help you understand how payments are applied, but it’s always worth giving them a call for clarification.
If you only take away two points, let it be these: when you make a payment toward your student loans, your money is going toward the interest on your loan first, and then on the principal. To reduce the amount of interest you pay over the life of your loan, make extra payments when possible.