Back to Basics: What is Student Loan Interest and How is it Calculated?

Michael Lux Blog, Student Loans 3 Comments

What is interest?

Put simply, interest is the cost of borrowing money.  When you take out a student loan, you agree to pay the loan back in full, plus interest.

In most cases interest accrues daily.  This means that everyday your student loan balance is growing.  As you pay off your loan the principal (the amount you need to repay) is reduced.  As the principal balance gets lower, your daily interest also gets lowered.

How is my daily interest calculated?

To calculate your daily interest, first find your interest rate.  This number can usually be found on a bill, statement, or on your lender’s website.  The interest rate given is your yearly interest rate.  To find your daily interest rate, take the yearly interest rate and divide it by 365.  For example, if you have 6.8% interest, your daily rate will be .068/365 or .0001863.

To find out how much daily interest you owe, multiply the balance of your loan by the daily interest rate.  Using our previous example, if the balance of your loan is $15,0000.  You would take that 15,000 and multiply it by .0001863, giving you a result of about $2.79.  This number means that with each passing day, you owe an extra $2.79 to your lender.  In a given month, your loan will be generating over $83 in interest alone.  If you make monthly payments of $83 or less, your balance will actually go up each month!  If your payments are only slightly above that $83 of monthly interest, it means your principal balance is only going down slightly and that it will take longer to pay off your loan.

What determines my interest rate?

If you have a fixed-rate loan, your interest rate will stay exactly the same for the life of the loan.  This rate is agreed upon between you and your lender when you sign for the loan.  Factors that could affect your interest rate include your credit score and yearly income.  Having a co-singer can sometimes cut the interest rate.  Lenders are always concerned with your ability to pay and the better your ability to pay, the more comfortable they will be with offering you a lower interest rate.

If you have a variable-rate student loan, your interest rate can change on a yearly basis.  When the loan is signed, the interest rate is tied to an index rate.  The index rate could be based upon US Treasury interest rates or the LIBOR rates.  As the index rate goes up and down on a year to year basis, your interest rate will similarly go up and down.  For example, your interest rate could be set at the 10-year treasury bond rate plus 2.5%.  That means that your rate will go up and down with the treasury bond rate.

Can I lower my interest rate?

Changing your interest rate is tricky.  Once you have agreed to the loan, lenders don’t want to lower the rate because it reduces the profits that they will make.  However, there are a couple of ways you can get your interest rate lowered.

If you have fallen behind on your loans and can’t keep up with the interest that is being added every day, some lenders will temporarily lower your interest rate to help you get caught up.  Sallie Mae calls this program their rate reduction program.  Other lenders, such as Navient, have similar programs.

If you are on the other end of the spectrum and have great credit and a strong income, you can refinance or consolidate your student loans with another company.  If you have just one loan, it is called refinancing.  When you refinance, a new lender pays off your old loan entirely, and you agree to a new, hopefully lower, interest rate and new terms with a new lender.  If you have multiple loans, it is called consolidation, and it just means that your new lender is paying off many loans instead of just the one.

Companies like LendKey and Laurel Road provide consolidation services and currently offer rates below 2%!  If you do have a great income and credit score it means lenders will compete for your business.  The student loan consolidation and refinancing business is currently so competitive that lenders like CommonBond and SoFi are even will to pay $150 to you up front, just to get you to sign up.

Bottom Line

Interest is your worst enemy when it comes to your student loans.  The more interest you pay, the bigger the profits are for your lender.  To pay less in interest you either have to be lucky enough to get a lower interest rate or you need to pay off your loan faster.