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Understanding Student Loan Interest Accrual, Compounding Interest and Crazy Lender Math

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Interest is the enemy of a borrower trying to repay their student debt. Payments towards interest do not lower the loan balance. Instead, payments towards interest are how lenders generate profit.

It should come as no surprise that most lenders will try to maximize the portion of payments that count towards interest while minimizing what lowers the loan balance. Today we will look at lender tactics and go over some critical terminology that lenders use, such as interest accrual, compounding, and capitalization.

Accrued interest is the interest charged daily on most student loans, which means a loan balance is going up daily. Interest capitalization occurs when the interest that has accrued is added to the principal balance. Capitalization normally happens monthly. Compound interest is the term used to describe paying interest on the interest that was added to the principal balance.

The key to smart and efficient student loan repayment is to reduce the spending on interest and maximize payments towards the principal balance. Borrowers who understand how interest is charged are best positioned to catch lender errors and to pay off their loans as quickly as possible. Several tricks and strategies can be used to reduce interest spending. Certain federal student loan borrowers are also able to avoid interest capitalization.

Processing Payments: Interest, Fees, and Principal

The objective for any borrower should be to reduce the principal balance. When the principal balance is paid in full, the loan is eliminated.

It should come as no surprise that lenders prefer to apply payments towards interest rather than the principal balance.

Most lenders apply payments in the following order:

  1. Fees – If the account has any late fees or any other fees, these are paid in full first.
  2. Interest – Any unpaid interest associated with the account is next paid in full.
  3. Principal* – The remainder of the payment is applied to the principal balance.

The * at the end of principal is there because some lenders like to get “creative” with this portion of the payment. Borrowers who are paying more the minimum do so because they want to knock down the principal balance. In theory, the extra payment should count 100% towards the principal balance.

Unfortunately, some lenders, such as Sallie Mae, will take the overpayment and apply it to the amount due on the next billing statement. For borrowers who are trying to pay off their loans as fast as possible, this can be a significant headache. It can also create a temptation to pay less in future months. Issues with this practice were raised in a class-action lawsuit against Navient, and though the suit was ultimately dismissed, the handling of overpayments is something that borrowers should monitor.

The best course of action for borrowers with lenders who apply the overpayment to future billing statements is to contact their lender and instruct them that overpayments are to be applied to the principal balance rather than future payments.

Does student loan interest compound daily?
A common misconception about student debt is that the interest compounds daily. With most loans, interest accrues daily. However, this interest is usually added to the principal balance only once per month. Thus, the interest can be said to compound monthly.

Student Loan Interest Calculations

Calculating the accrual of interest on a student loan is relatively simple. It can be done manually or using an interest calculator online.

To calculate interest manually – To determine the daily interest generated by a student loan, take the loan balance and multiply it by the interest rate. Then divide by 365. For example, a $10,000 loan at a 5% interest rate would generate $1.37 per day of interest. ($10,000 * .05 / 365 = $1.37)

To calculate the interest online – There are many interest calculators online. This calculator makes the process simple and is ideal for estimating interest generated in a day, a month, a year, or over the life of the loan.

Does student loan interest accrue during school?
Many student loans come with special rules for students who are still in school. With the notable exception of a federal subsidized loan, student loans do accrue interest during school.

Student Loan Interest Rates

The interest rates on student loans vary from loan to loan. Some loans have interest rates that can change while others are fixed. These terms are set when the borrower signs the loan contract. The good news for borrowers is that there are many ways to get interest rates lowered.

There are many factors that determine the original interest rate on the loan. For federal government loans, the rate is set by Congress. For private loans, factors such as borrower credit score, economic conditions, and lender cashflow can all affect the interest rates offered.

Generally speaking, when the interest rate of a loan suddenly goes up, it is because it is a variable-rate loan. These loans are tied to an index rate such as the LIBOR, which is a rate banks use to determine the interest rate when lending to other banks. Variable-rate loans usually change quarterly (four times per year), but depending upon the original student loan contract, the rate may move monthly or yearly. Most lenders do not have an obligation to tell borrowers if their rate has gone up. An increase in interest rate may also mean higher monthly payments.

Lenders are rarely willing to negotiate a lower interest rate, but there are at least 14 other ways to get a lower interest rate. Not everyone is able to turn their good credit score into a lower rate by refinancing, but programs also exist for borrowers who are struggling to repay their debt.

Preventing Student Loan Interest Accrual and Interest Compounding

Other than paying a loan back in full, it is nearly impossible to avoid a loan accruing interest. A notable exception would be for federal subsidized loan borrowers. These borrowers can prevent future interest accrual if they qualify for a deferment. Federal student loan borrowers who are fighting cancer may also be able to stop being charged interest on their loans.

Preventing interest compounding, or capitalization, is straightforward. As long as a borrower makes monthly payments that are larger than the monthly interest, the loan balance will not grow, and the borrower will not have to pay interest on the interest that accrues each month. Things get more complicated for borrowers who are in school or who are on an income-driven repayment plan making payments smaller than the monthly interest accrual. These borrowers want to avoid events that trigger interest capitalization.

Next Step:

The best way to combat student loan interest accrual is to find a way to get lower interest rates. We have found 14 different methods.