When it comes to interest rates and student loans, most people know one thing: a lower interest rate is better than a higher interest rate. For the 2020-21 school year, the good news is that student loans are being offered at historically low interest rates, so there are many good deals to be had.
However, it’s probably no surprise that there’s more to an interest rate than meets the eye. Digging into the fine print can reveal ways to pay off your loan faster — and it can also expose the landmines that could end up costing you additional money.
So today, let’s ditch the “bank speak” and talk like humans. Let us give you the scoop on how interest rates can work with you or against you.
What are interest rates?
Put simply, interest rates are fees that lenders charge so they can make money on loans.
When you repay your loan each month, the money goes two places:
- First, toward that month’s interest payment (because you have to pay up-front for the bank’s loan services), and then
- Toward the loan’s principal, or the actual amount of money that you borrowed.
When you get your bill every month, interest and principal will be broken out separately. That’s because they’re like separate pots of money, which we’ll discuss in a few minutes. But for now, know that principal and interest are never added together — that is, as long as you keep your loan current.
Now, let’s do some math. (Don’t worry. We’ll make it simple.)
How do interest rates work?
Depending on your credit worthiness and the type of loan you get, you can expect to pay somewhere between 1.25% and 12% interest for the money you borrow as part of a college loan.
Interest rate is expressed as an APR, or annual percentage rate. The APR refers to the amount of interest that is charged over one year.
Let's use some round numbers to make this easy. If you have a 10,000 loan at 5% APR, you might expect to pay around $500 in interest during the first year of the loan.
The simple equation is:
$10,000 principal x .05 APR = $500 in interest
However, the amount you actually pay depends on how the interest rate is applied. Yes, this is where that fine print comes in, but remember, we promised to make it easy so stick with us.
How is student loan interest calculated?
The thing to remember about interest is that it’s not a once-and-done calculation. Rather, interest is re-calculated, or “compounded,” at specific intervals. Many student loans are compounded daily.
While that may sound confusing, know that compounding is built to work in your favor if you keep current on your loan. The idea is that with each on-time payment that you make, you’re paying slightly less toward interest and slightly more toward principal.
Let’s go back to our $10,000 loan at 5% interest to illustrate how daily compounding works over time. To keep it simple, we’ll look at a two-month period.
With daily compounding, the 5% APR is divided by the 365 days of the year to come up with a daily interest rate.
5% APR / 365 days = .0137% daily interest
The lender will apply .0137% interest to your principal every day. On the very first day that interest begins to accrue on your loan, (that is, the first day interest is charged) the calculation would look like this:
$10,000 principal balance x .000137 daily interest rate = $1.37 in interest
The interest for day one of your loan would be $1.37.
Every day, from day one until you make your first payment, your lender would run the same calculation.
Day 1: 10,000 x .000137 = $1. 37
Day 2: 10,000 x .000137 = $1. 37
Day 3: 10,000 x .000137 = $1. 37
Month 1: $1.37 interest per day x 30 days = $41.10 in interest
So on day 30, your balance is $10,000 in principal and $41.10 in interest. Note that your principal didn’t change, only your interest did.
Let’s say you make your first payment on day 30. If your monthly payment is $150, $41.10 would be applied to interest (because that always gets paid first) and $108.90 would be applied to the principal.
Month 1: $150 payment - $41.10 interest = $108.90 applied to principal
After your first payment, your principal would be reduced to $9,891.10. When your bank compounds interest on day 31, the equation would look like this:
Month 2: $9,891.10 principal balance x .000137 daily interest rate = $1.36 daily interest
If you make your next payment 30 days later, your interest for the second month of your loan would be $40.80.
Month 2: $1.36 interest per day x 30 days = $40.80 in interest
For your second payment, $40.80 of your $150 payment would go to interest, leaving you $109.20 to apply to principal. Now your principal would be $9,781.90.
How about we summarize this in a handy table? Here's a simplified amortization table, showing how you make a little more progress on your principal each month.
|Loan Balance||Interest||Principal||Monthly Payment|
How compound interest works in your favor
Looking at the examples above, it’s easy to see how this effect works over time. You naturally make a little more headway on your principal every month, even though your payment amount remains the same. This is known as amortization.
If you use amortization to your advantage, you can save yourself a lot of money over the life of your loan.
If your loan doesn’t have prepayment penalties, you can pay it off faster by making higher payments every month. Because you’ve already paid the interest for that payment period, any additional money will go right toward the principal.
That will have a lasting benefit, because a lower principal amount means that those daily compounding calculations will be applied to increasingly smaller numbers.
Paying as little $10 extra per month can yield significant savings over the life of your loan. Paying $100 extra or more can save you thousands.
Fixed v. variable interest
Now that we’ve discussed how interest works, let’s discuss the different kinds of interest rates. There are two kinds of interest that apply to student loans: fixed and variable.
Fixed means that you’ll pay the same interest rate for entire period of time that you hold the loan. Your interest rate will be 100% predictable.
Variable means that the interest rate may fluctuate based on market conditions. While variable rates may sometimes be lower in the short-term, the danger is that they may suddenly increase.
Besides paying significantly more interest every month, your monthly payment may also increase. If your payments increase so much that you’re not able to keep up with them, your interest could start capitalizing and the size of your loan could snowball quickly. (What does capitalize mean? We’ll discuss that in a minute.)
So are variable interest rate loans ever a good idea? In some cases, yes. If interest rates are predicted to go down, and they do, then variable interest rates may offer a great bargain. Variable interest rates may also make sense if you plan on paying off a loan quickly, or if you’re able to refinance when rates get higher.
Landmine alert: capitalization
Whether you have a fixed or variable interest rate, interest generally starts to accrue as soon as the money is disbursed to you or to the school. Subsidized federal loans may offer the only exception, in that the federal government covers the interest while you're still in school.
That’s why, if at all possible, you should make payments while you’re in school — even if the lender allows you to defer payments until after you graduate.
Remember those landmines we mentioned earlier? Here’s a big one.
Interest that accrues without payment can capitalize. That means that the unpaid interest gets added to your principal. Once it’s added to your principal, you can be charged interest on it.
Let’s use the same numbers from our daily compounding example.
If you accrue $41.10 in interest during the first month of your loan and don’t make a payment, your principal can increase from $10,000 to $10,041.10. Then, after that, the daily compounding rate would be applied to the new principal, meaning that you’re being charged interest on interest.
If you defer interest payments until you’re out of school, you could potentially wind up adding thousands of dollars to your principal.
On the flip side, making interest-only or interest-plus-principal payments while you’re still in school can save you thousands of dollars over the life of your loan.
If you find yourself unable to pay, the federal government and some private lenders may allow you a period of forbearance, which is a period of time in which you don’t have to pay your loan. However, interest usually still accumulates and capitalizes during that time, so you’re likely to end up with higher payments after the forbearance is over.
How to evaluate interest rates
The interest rate you receive will depend on your (and/or your cosigner’s) credit rating and other financial considerations. Keep in mind that most students need to apply with a cosigner when seeking a private student loan.
For the 2020-21 school year, student loan rates are hitting record-low levels.
To make sure you're getting the best deal possible, get rate quotes from several different lenders before making a decision. Most lenders can offer you an instant quote, either online or on the phone, within minutes, and without impacting your credit score.
How to choose a loan
If you’re trying to choose between student loan providers, there are few things you should consider, including:
- Interest rates
- Loan eligibility requirements for you or your cosigner
- Repayment terms, such as number of years, options for paying while in school, penalties for early repayment, and grace periods after you’re no longer in school
- Options for forbearance if you can’t pay for some reason
- The lender’s reputation
If you’re looking for a private student loan, it’s important to make sure that you’re working with a lender that doesn’t issue predatory loans, that is, loans with terms that are likely to put the borrower into default.
Check out our picks for the best deals on private student loans.