How Student Loan Interest Rates Work | Student Loans and Advice

It seems like by the time you graduate from college, you should have a basic understanding of how personal finance works. Unfortunately, that’s not always the case.

Even though student loans are common – in 2021, almost 64% of college graduates had borrowed money for school, according to U.S. News data – students may not understand student loan interest rates. That’s a shame, because knowing how student loan interest works can help you save a lot of money.

Read below to learn how student loan interest is calculated, when your loan will start accruing interest and how to lower your interest rate.

Federal student loans have fixed interest rates, which means that the interest rate will stay the same for the life of the loan.

Interest rates for federal direct student loans depend on the type of loan and update every year. The federal government bases rates on the 10-year Treasury note rate. If the rate for 10-year Treasury notes goes up, so will student loan interest rates, up to a cap.

For loans disbursed between July 1, 2022 and July 1, 2023, the interest rate is 4.99% for undergraduate direct subsidized loans and direct unsubsidized loans and 6.54% for direct unsubsidized loans to graduate and professional students. The interest rate for direct PLUS Loans, including Graduate PLUS Loans and Parent PLUS Loans, is 7.54%.

COVID-19 emergency relief has paused payments on federal student loans since March 2020. That pause is still in effect until 60 days after June 30, 2023 or until the Supreme Court makes a ruling on President Joe Biden’s student loan forgiveness program.

Private student loan companies are allowed to set their own interest rates, which may be higher or lower than rates for federal loans. Interest rates on private loans may be fixed or variable. With a variable rate, your interest rate may change monthly, quarterly or annually, depending on outside market forces.

A variable-rate loan may have a lower starting point than a fixed-rate loan. However, you run the risk of the rate increasing, which will result in a higher loan payment. It’s impossible to know for sure what will happen with interest rates in the future, but if you believe interest rates are going to fall, then a variable-rate loan may save you more money than a fixed-rate loan.

“Usually with a variable rate, future rates are expected to be higher. But currently, there’s not as much potential risk with a variable rate,” says Matthew P. McKee, a certified financial planner at Target Rock Wealth Management. Based on the yield curve, rates are expected to be lower in the future, McKee says.

Borrowers who want more certainty in their monthly budget may opt for a fixed-rate loan. If rates drop in the future, they can refinance.

Unlike with federal student loans, the rate for private student loans may depend on factors such as the borrower’s credit score and income. The loan amount and term can also affect the interest you pay. Longer terms generally have higher interest rates than loans with shorter terms.

Some lenders may charge different rates for undergraduate or graduate loans. Also, you may generally receive a lower rate if you have a qualified co-signer. A co-signer is a person who is legally bound to take over payments if you default.

Federal student loans and most private student loans charge simple interest, but there are some private loans that charge compound interest. Simple interest is calculated on the principal balance, and compound interest is calculated on the principal balance as well as on unpaid interest.

As a borrower, it’s in your best interest for loans to use simple interest and not compound interest. Make sure to ask the lender how they calculate interest before finalizing the loan.

“You have to pay attention when comparing two loan options if both of them seem to have the same rate, but have different terms in times of compounding,” says Bradley Hilton, a CFP at Sonas Financial Planning.

Interest on federal student loans is calculated as simple interest. To calculate interest charges on a loan with simple daily interest, you can use this formula:

Interest = (Outstanding principal balance x interest rate factor) x Number of days since the most recent payment

The interest rate factor is your interest rate divided by 365 or 366 during a leap year.

Let’s say your principal balance is $30,000 with a 5% interest rate. It has been 30 days since your last payment. In this case, your interest amount is $123.29.

If you have direct subsidized loans, you won’t be charged interest while you are in school or during a six-month grace period. However, direct unsubsidized loans and direct PLUS loans start accruing interest immediately.

Borrowers can make payments in school and during the grace period to lower the accrued interest. If you do not, the unpaid interest may be rolled over into the principal. This is known as interest capitalization. Capitalization will result in more total interest accrued over the life of the loan.

Interest for private student loans may start accruing as soon as the loan is disbursed, depending on the lender. Some private loans also have a grace period immediately following graduation or dropping out, during which time payments are not due. Interest may accrue during this time and be capitalized after the grace period ends, unless the borrower has paid off the interest charges.

There are only a handful of ways to lower your student loan interest rate. If you have federal student loans, signing up for automatic payments can lower your interest rate by 0.25 of a percentage point. Many private student loan companies offer a similar discount.

This can save you hundreds of dollars over your loan term. For example, let’s say you have $50,000 in student loans with a 7% interest rate and a 10-year term. If you switch to autopay, your new rate will be 6.75%. In this case, you would save $771 in total interest over the life of the loan.

One of the only other ways to lower your interest rate is to refinance your loans with a new lender. Refinancing entails signing a new loan agreement, often in exchange for a lower monthly payment, lower interest rate or both.

Refinancing your federal loans will result in losing benefits like access to loan forgiveness programs and income-driven repayment plans. Refinancing is a permanent process and cannot be undone.

There are fewer risks to refinancing private loans, but borrowers should read through the loan details carefully. They should understand if the lender will use simple or compound interest, if the rate is fixed or variable, what the total interest will be and what the payment will look like.