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

A basic understanding of student loan interest is essential to ensuring that lender mistakes get identified and corrected.

Written By: Michael P. Lux, Esq.

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Interest is the enemy of borrowers working to repay their student debt. Lenders use tools like daily interest accrual and compound interest to drive up profits and keep borrowers in repayment.

The key to effectively and efficiently managing student loan repayment is to minimize the amount spent on interest and maximize payments toward the principal balance.

Borrowers who understand how interest is charged are better-positioned to identify any lender errors and to pay off their loans more quickly. Here, we will explore some of the tricks and strategies that borrowers can use to reduce interest spending.

Student Loan Interest Basics

Payments made towards interest do not reduce the loan balance. Rather, those payments are how lenders generate profit.

Accordingly, it should come as no surprise that most lenders try to structure repayment in a way that maximizes the portion of payments that apply towards interest while minimizing that which reduces the loan balance.

Student loans generate interest daily. Accrued Interest is the total amount of interest that has built up over time on the loan. Interest Capitalization occurs when the lender adds that accrued interest to the principal balance.

When lenders send the bills each month, they usually show the accrued interest added to the balance. This might give some borrowers the impression that lenders are capitalizing interest once a month. However, borrowers should understand that their loans are actually accruing interest daily.

Once the loan balance includes the accrued interest, lenders can then charge interest on that new loan balance. This concept of paying interest on the accrued interest is known as compound interest. Student loans accrue interest daily, but typically compound monthly.

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.

Because lenders prefer to apply payments towards interest rather than the principal, lenders typically prioritize payments in this order:

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

* Some lenders like to employ “creative” methods with this portion of the payment. Borrowers who pay more than the minimum do so because they want to knock down the principal balance. Ideally, the extra payment would count 100% towards reducing the principal balance.

Unfortunately, some lenders, such as Sallie Mae, apply the overpayment to the amount due on the next billing statement. For borrowers 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. Plaintiffs in a class-action lawsuit against Navient highlighted the issues with this practice. Though the plaintiffs ultimately dismissed the lawsuit, the handling of overpayments is something that borrowers should monitor.

For borrowers facing this issue, the best approach is to explicitly instruct their lender to apply any extra payments towards the principal, not towards future payments. This ensures that extra payments have the desired impact of reducing the loan balance more quickly

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. Borrowers can do this calculation manually or using an interest calculator.

To calculate interest manually – To determine the student loan’s daily interest, 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 online calculators. 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. While some loans have interest rates that can fluctuate over time, other loans’ rates remain constant. These terms are set when the borrower signs the loan contract. Fortunately, there are a few strategies for reducing student loan interest rates.

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, such as LIBOR, which banks use to determine the interest rate when lending to other banks. Variable-rate loans typically change quarterly (four times per year), but the rate may move monthly or yearly depending upon the original student loan contract. When the interest rate increases, this may lead to higher monthly payments. However, most lenders do not have an obligation to tell borrowers if their rate has gone up.

Many factors can impact the original interest rate. For example, Congress sets the rates of federal government student loans. For private loans, factors such as borrower credit score, economic conditions, and lender cashflow can affect the interest rates offered.

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

Exploring all available options to reduce your interest rate can significantly impact the overall cost of your loan and your monthly payment obligations.

Preventing Student Loan Interest Accrual and Interest Compounding

Aside from fully repaying a loan, it is nearly impossible to prevent interest accrual. There are exceptions, however. For example, federal subsidized loan borrowers who qualify for a deferment can avoid future interest accrual. Federal student loan borrowers undergoing cancer treatment may also qualify for a suspension of interest charges 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.

For some federal loan borrowers, however, preventing compounded interest can be more complicated. Federal borrowers on an income-driven repayment plan often make payments that are less than than the monthly interest accrual. These borrowers can take steps to prevent or limit compounding interest by trying to avoid the events that trigger interest capitalization.

The most effective strategy to mitigate the impact of student loan interest is to secure a lower interest rate. We have identified a number of different methods borrowers can use to lower their interest rates. Doing this can significantly lessen the financial burden of accruing interest over the life of a loan.

About the Author

Student loan expert Michael Lux is a licensed attorney and the founder of The Student Loan Sherpa. He has helped borrowers navigate life with student debt since 2013.

Insight from Michael has been featured in US News & World Report, Forbes, The Wall Street Journal, and numerous other online and print publications.

Michael is available for speaking engagements and to respond to press inquiries.

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