Determining when student loan interest is added to the balance appears complicated at first glance.
Interest accrues daily, is billed monthly, but is only added to the principal balance after certain events.
I know that sounds like a complicated mess. By the end of this article, the student loan interest timeline will make more sense, and you will understand how to use this mess to your advantage.
Student Loan Interest Accrues Daily, But it Doesn’t Get Added to the Balance
Student loans generate interest every day.
Think of it like your electric bill. Every day you are using electricity. You don’t receive a daily bill. Yet at the end of the month, you can be certain you will receive a bill adding up each day’s expenses.
Student loans work similarly. Each day your lender is charging interest. Lenders and servicers may not show it on the student loan portal, but they are tracking it.
The Monthly Student Loan Bill
Each month your lender sends out a bill listing the interest charges for the month. That number isn’t based upon a monthly rate. Instead, it is the sum of the daily interest charges.
You may notice that months based upon a 31-day bill have higher interest charges than the months based upon a 30-day cycle.
Borrowers can utilize this fact by paying their student loan bills as early as possible. Waiting until the due date means the daily interest accrual is based upon a larger loan balance. Making payments a few days early means the balance will be slightly smaller for those few days. The difference in savings isn’t significant, but for larger balances, it can add up over the course of many years.
In most cases, the monthly payment is larger than the monthly interest. Borrowers in repayment will see their balance go down with each payment.
Borrowers who are not making payments, or who make payments smaller than the monthly interest, will see their balance go up.
Compounding Interest, Capitalized Interest, and Growing Student Debt Balances
The big danger with a growing student loan balance is that it can spiral out of control.
If the balance grows, more interest is charged. As more interest is generated, the balance grows even faster. Paying interest on the interest is known as compounding interest.
Fortunately, borrowers do not immediately start paying interest on the interest that accrues daily. In fact, federal student loan borrowers don’t even pay interest on the interest that is charged on each monthly bill.
Paying interest on the interest happens after capitalization. Interest is capitalized when it gets added to the principal balance of a loan.
Outstanding interest is the term federal servicers use to track the extra interest that has not yet been capitalized. Most federal servicer portals will show a borrower’s current balance, principal balance, and outstanding interest.
It is better to have federal student debt classified as outstanding interest because there isn’t a daily interest charge. Once capitalization happens, and the outstanding interest gets added to the principal balance, borrowers start paying interest on the interest.
As a result, interest capitalization can be very expensive for federal student loan borrowers. It is possible that a borrower could go years without having their loan capitalized. If an event triggers a capitalization, the principal balance could easily jump by thousands of dollars.
Avoiding Interest Capitalization on Federal Student Loans
In some cases, interest capitalization is unavoidable.
A common example of unavoidable interest capitalization is a borrower entering repayment after college. Federal direct consolidation also triggers interest capitalization.
Other times, responsible borrowers can avoid interest capitalization. For example, if you are on an income-driven repayment plan and miss your income certification deadline, you are automatically enrolled in the standard repayment plan. Changing repayment plans triggers interest capitalization. Thus, for borrowers on IDR plans, missing an income certification deadline could be very expensive.
Borrowers concerned about interest capitalization should review this article on avoiding capitalized interest on federal student loans.
Interest is the Enemy of Student Loan Repayment
The fight against student loan interest often leaves borrowers with two main strategies to efficiently eliminate their debt.
The borrowers who have increasing balances because they cannot keep up with interest should investigate the many options available for student loan forgiveness.
The borrowers knocking out their debt and fighting the daily interest should explore the strategies to get a lower student loan interest rate.