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How Does Interest Work On a Student Loan?
Like most types of loans, student loans require repayment with interest. Most borrowers understand this, but can still be left wondering “how does interest work on a student loan?” Interest can work in a few different ways. Continue reading to learn more!
What is interest?
Interest is the cost of borrowing money. A loan’s interest rate takes the form of a percentage of the current loan balance. Interest adds up over time, and it is the first thing that monthly payments cover. In many cases, interest can end up making a borrower’s debt larger. That’s why it is important to understand how it works.
Fixed vs. variable interest
There are two types of interest rates: fixed and variable.
Fixed interest rates remain the same over the life of the loan. The percentage does not increase or decrease. Variable interest rates, on the other hand, fluctuate throughout the life of the loan. This means your interest can be higher or lower month-to-month. Variable interest rates are based on economic benchmarks that reflect the market such as the LIBOR.
Subsidized loans vs. unsubsidized loans
The US Department of Education disperses subsidized loans to students who show financial need. Subsidized loans do not accrue interest while the borrower is in school. They also do not accrue interest during the 6-month grace period and in periods of deferment. This is because the government takes on the responsibility of paying the interest.
Unsubsidized loans can be disbursed by the Department of Education or by private lenders. Unsubsidized loans begin accruing interest immediately once you receive the funds. Borrowers will not need to pay the interest while they are still in school and during their grace period. The interest will be capitalized at the end of the grace period.
Capitalization occurs when accrued interest is added to the principal loan balance. When your loan is capitalized, it raises the total loan balance, which could result in borrowers paying more in interest over time.
Capitalization occurs on unsubsidized loans when payment begins. Interest can also be capitalized after periods of deferment or forbearance or when a borrower leaves REPAYE, PAYE, or IBR income-driven repayment plans.
See also: Income-driven repayment plans
Federal student loan interest
All federal student loans have fixed interest rates. Below is a chart displaying interest rates for Direct federal loans disbursed on or after July 1, 2021, and before July 1, 2022:
|Loan Type||Borrower Type||Interest Rate|
|Direct Subsidized and Direct Unsubsidized loans||Undergraduate||3.73%|
|Direct Unsubsidized loans||Graduate||5.28%|
|Direct PLUS loans||Parents and graduate/professional students||6.28%|
Federal loans are daily interest loans, meaning that interest accumulates every day. Borrowers can calculate how much interest accrued in a month by multiplying their current outstanding balance by the interest rate. Then, divide that number by the amount of days since your last payment.
Private student loan interest
All private loans are unsubsidized, so they will accrue interest from the time that you take them out. Private loans may have fixed or variable interest rates, depending on the lender. You can find information about the interest in the promissory note for the loan.
Keep track of your loans
When it comes time to start repaying your student loans, it’s essential to be aware of how interest works and how it will affect your payments. Be sure to keep track of the interest information, such as the rate and fixed or variable, for each of your student loans. This will help you strategize which loans to prioritize in repayment. Typically, private loans have higher interest rates and should be prioritized. If you pay off the loans with higher interest rates first, you’ll end up repaying less overall!