Do student loans have compound or simple interest?
Key takeaways
- There are many different types of student loans, but most student loans — including federal student loans — have simple interest.
- Simple interest is interest you pay only on the amount borrowed, while compound interest requires you to pay interest on the amount borrowed plus any accrued interest.
- There are some circumstances where federal student loans may have compound interest, and some private student loans also have compound interest.
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:
- 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.
Subsidized vs. unsubsidized student loan interest
Subsidized and unsubsidized student loans are two types of federal student loans. Subsidized student loans are student loans given to students demonstrating financial need. On these loans, the government pays the interest that accrues while a student is enrolled in college for at least half-time, minimum six credit hours. Unsubsidized student loans are other options, but the interest on these loans is not paid by the government and begins accruing as soon as the funds are disbursed.
Since both of these are federal student loans, the interest works like any other federal student loan. They have simple interest. The main difference is that unsubsidized student loans accrue interest from the start, while subsidized student loans do not accrue any interest while the student is enrolled in college. Both types of loans have the same interest rates put in place by the Department of Education.
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.
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.
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