You make a loan payment. The total debt goes down.
Then you come back the next day. The loan amount is back up to where it was before your payment.
Having some deja vu?
This is because of interest. Let’s break down what interest is, how it works, and why your total loan balance may be going up so quickly.
What Is Interest?
Interest is essentially the amount you pay a lender to use their money to pay for college. When a lender decides to give you money, they make a profit off of the interest paid over time on top of the original loan amount.
Most lenders understand that students will not be able to make loan payments while in school and often don’t require payments until a few months after you leave school. However, this does not mean that interest isn’t accruing on the overall debt amount. This means that the amount you owe can go up, and fairly rapidly if you don’t pay close attention to it.
How Does Interest Work?
It’s one thing to understand the concept of interest, but it’s another thing to really understand how it’s calculated. Let’s break it down.
(As a refresher before we get started, principal is the initial amount you agreed to pay back. Interest is the price you pay to borrow that money. For example, if you borrowed $30,000 to pay for college, and your loan balance is currently $40,000, $30,000 of that is principal, and $10,000 of that is interest.)
When you make a required monthly loan payment, you’re making a payment on the interest before any money goes toward reducing your principal. Whatever is left over after paying the interest is then put towards the principal balance. Over the life of your loan, the interest paid will go down each month, which subsequently allows you to put more towards your principal.
To break this down even further, we’ll use an example with some simple numbers.
Say you borrowed $100 from a lender some years ago, and your balance is now $120. You owe $100 in principal and $20 in interest. If you make a $10 payment towards your debt, you will be paying $10 towards the interest on your debt, bringing your overall total debt down to $110. However, the amount you just paid hasn’t chipped away at actually paying back what you initially borrowed. You simply paid part of what the lender is charging you to borrow that money.
How Does Interest Compound?
Interest is typically compounded daily. So what exactly does that mean?
The annual interest rate is divided by 365 (the days in the year) to get your daily interest rate. That is how much your interest will compound daily. The kicker is that if you aren’t making loan payments, the interest is compounding on a larger and larger amount.
This is what that can look like: (Get ready for some *quick maths.*)
Let’s say you borrowed $10,000 from a lender with a 5% interest rate.
Your daily interest rate would be roughly 0.014% (5% ÷ 365).
On day 1, your total loan debt would be $10,000.
On day 2, it would be $10,001.40.
For day 3, your interest would be calculated based on this new amount of $10,001.40, meaning…
Day 4, your total loan debt would be $10,0002.80.
At the end of a year, you would have accumulated a decent chunk in interest.
This compounding takes place when you are in school and beyond, so, you can imagine how this number can increase so rapidly if you aren’t making payments while in school.
How Much Interest Will I Pay?
This will vary from person to person depending on your total loan amount and the interest rate.
The average student loan accrues $26,000 in interest over the course of 20 years1. This interest ends up being around 67.1% of the average borrower’s total cost of repayment. This means that over half the amount paid over time is strictly from interest.
For a specific calculation based on your individual loan information, we recommend using Sallie Mae’s Accrued Interest Calculator.
What is Considered a High Interest Rate?
This might lead you to ask about what is considered to be a good interest rate. The reality is, interest rates vary greatly by lender and type of loan. So, it’s hard to say what is good and what isn’t.
Generally speaking, anything at or above 10% is considered a very high interest rate for student loans. Interest rates at 7% and below is a much better place to be.
Between 2006 and 2021, the average federal student loan interest rates were:2
4.66% for undergraduates
6.22% for graduate students
7.27% for parents and grads who take out PLUS loans
In May 2018, the average private loan interest rates were:3
6.17% for borrowers with 5-year variable-rate loans with a cosigner and beginning repayment immediately
7.64% for borrowers with 10-year fixed-rate loans with a cosigner beginning repayment immediately
How Can I Lower the Amount of Interest that Accrues?
The best way to prevent your total debt amount from rising so rapidly is to make at least the minimum monthly payments. On top of that, you can also save on interest by making biweekly and surplus payments.
If possible, you should always aim to pay off the interest that has accumulated to keep the loan at its initial amount.
Final Thoughts from the Nest
Interest is almost always part of taking out a student loan. Making educated decisions about what loans you take out and the interest rates associated with them is the most important piece to this equation. Always be sure to compare your loan options before agreeing to any one lender.
If you already have a student loan and struggling to make payments or think you may be able to get a lower interest rate, it may be time to consider refinancing.