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Do Student Loans Have Compound Or Simple Interest?

Do Student Loans Have Compound Or Simple Interest?
Written by Publishing Team

With student loans, borrowers pay a set amount of money toward the principal each month, but they also charge an additional percentage in the form of interest. In most cases, student loans charge little interest, which means you don’t pay interest on unpaid interest. Here’s what you need to know about simple versus compound interest and how to calculate each.

Do student loans have compound or simple interest?

All federal student loans and most private student loans charge simple interest instead of compound interest.

With simple interest, you pay interest only on your principal amount and interest does not accrue on unpaid interest. For this reason, you pay less interest over the life of your loan. With each monthly payment, you pay the full amount of interest you owe for that month.

With compound interest, on the other hand, you will inevitably pay more interest over time. This is due to the fact that compound interest allows the lender to charge interest on your balance and on unpaid interest that accrues over time.

Are Federal Student Loans Compound Interest?

There are a few scenarios in which interest on federal student loans accrues. This is more common during student loan deferral periods where interest accrues on the amount you borrowed while you are temporarily not making the payments. This means that once the deferral period is over, you will typically owe more money than you owed when you originally requested a pause in your loan payments, as this unpaid interest is added to your loan balance.

Unpaid interest can also accrue any time you pay off your loans under an income-driven payment plan and your monthly payment is less than the amount of interest due each month. When you add unpaid interest to your outstanding balances in any of these cases, the act of increasing the loan balance is referred to as capitalization.

How does interest on a student loan work?

Student loan interest is calculated as a percentage of your primary balance. The interest is included in every monthly payment you make. If you have a fixed interest rate, your monthly payments will remain the same every month, even though the portion of the payment that is allocated to interest decreases with each successive payment. You can find out how this works with our Student Loan Calculator.

How is simple interest calculated?

To calculate simple interest, you’ll multiply your outstanding principal balance by the daily interest rate applied to your loan, and then multiply that result by the number of days in your repayment cycle. To come up with the daily interest rate on your loan, you would divide the interest rate on your loan by the number of days in the year.

Let’s say you have a $10,000 loan with an interest rate of 5.28 percent. Here’s how to calculate interest payments using simple interest:

  1. Find the daily interest rate: 0.0528 / 365 = 0.000144.
  2. Multiply the daily interest rate by your principal balance: 0.000144 x $10,000 = $1.44.
  3. Multiply the daily interest fee by the number of days in the payment cycle: $1.44 x 30 = $43.20.

This is the amount you will pay in interest during the first month of payment. When you pay off your principal, your monthly interest fee will decrease. For example, once your capital is reduced to $5,000, here’s what the formula looks like:

  1. 0.0528 / 365 = 0.000144.
  2. 0.000144 x $5,000 = $0.72.
  3. $0.72 x 30 = $21.60.

How is compound interest calculated?

While some private student loans rarely use the daily compound interest formula. In this method, the accumulated interest is constantly added to your balance. In the example above, the daily interest fee at the beginning of the repayment period, $1.44, will be added to your balance on the first day. The next day, you’ll find the daily interest fee by multiplying the daily interest rate by $1001.44, and so on. This is what it looks like:

  • Day 1: 0.000144 x $10,000 = $1.44.
  • Day 2: 0.000144 x 1001.44 = $1.4402.
  • Day 3: 0.000144 x $10,002.88 = $1,404.
  • Day 4: 0.000144 x $10.04.32 = $1.4406.

While the increase in your balance may only be a few dollars, the growth can be exponential the longer you don’t pay interest.

bottom line

If you owe money on student loans or plan to borrow for higher education in the future, you will likely be charged little interest on your loan balances. This makes it much easier to pay off student debt faster and avoids situations where the loan balance goes up faster than you can pay off. If you want to avoid paying more interest than necessary, you can always make extra payments on your loans and ask that they be paid toward principal.

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