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How Does Interest Work on Student Loans?
How Does Interest Work on Student Loans? – This article will help you understand how interest works on student loans and How to reduce the student loan interest you pay.
The fundamentals of student loans are quite straightforward; a lender gives you a certain amount of money to help pay for college. Once you graduate and begin your career, you repay the money. However, student loans, like other loans, generate interest on top of what was borrowed.
What is Interest?
Interest on any loan, is basically what it costs to borrow money. It is calculated as a percentage of the principal (the amount you borrow), and this percentage is known as the interest rate. Because of interest, you should always expect to pay back more than your initial student loan amount.
When do student loans start accumulating interest? Unlike personal loans, student loans do not accumulate interests immediately after they are taken out. Since there are quite a lot of different kinds of student loans, the exact point at which your loans begin to add interest may vary.
What are the Different Loan Types and Varying Interest Rates?
1. Subsidized Loans
Student loans from the federal government are either subsidized or unsubsidized. A “subsidized” loan means that the government will make interest payments on that loan while you’re in school. Technically, subsidized loans start to accumulate interest the moment you take them out. However, since the government is paying that interest while you’re in school, you don’t have to worry about paying a dime of it until after you graduate.
So, when do subsidized loans start accruing interest? From the moment that you take out a subsidized loan to the moment that your period of grace ends after graduation, the amount you owe will remain completely unchanged. After that, however, you’ll become responsible for the interest that accumulates on the loan at the agreed rate.
2. Unsubsidized Loans
Unsubsidized loans don’t have the same government support as their subsidized loans. For that reason, interest begins to accumulate immediately after you receive the loan and you are the one responsible for that interest from the beginning. You won’t have to pay anything until after graduation, but when you get your first student loan bill, you should expect the overall amount to be higher than what you initially borrowed.
3. Private Student Loans
Private student loans come from private lenders, so they don’t get any government support. Often times, your private student loans will begin to accumulate interest the moment they are taken out and, depending on the terms of your loan repayment plan, you may be responsible for paying that interest while you’re still in school. This is not necessarily a bad thing as it is a way to build credit while in school. It’s also important to remember that the interest rate on your private student loan can change with a number of factors.
What are the Factors Affecting Student Loan Interest Rates?
1. Personal Credit History:
Usually the most profound influence on your student loan interest rates is your individual credit history and financial profile. Fortunately, that also happens to be the easiest interest rate-impacting factor for you to exert personal control over as a borrower. As your credit score and track record become stronger, lenders will be more motivated to win your business, and to do so they may offer you lower, more alluring rates and terms.
Of course, credit history can also work against you if your finances become unmanageable and you have trouble paying bills on time. That is why it is so vital that you take steps to raise your credit score, earn and save as much money as possible, and pay all of your debts and loan obligations on time. Do those things and your credit should steadily improve.
2. Industry Shifts:
The rates charged on all consumer loans are tied to underlying interest rates that are set by the government or by the dynamics of supply and demand in the marketplace. If the Federal Reserve Bank, for instance, cuts the rates it charges to lend cash to financial institutions, then through a “trickle-down effect” the price those lenders charge to consumers will typically drop in tandem. If the Fed raises rates, usually consumer rates will eventually go up.
For that reason, these broader financial industry actions can have a significant impact on student loan rates. Tracking the sources and movements of major underlying rates can be complicated, but is not at all necessary in order for you to shop for an affordable student loan, refinance, or consolidation rate. Just compare loan rates from reputable lenders, who will automatically raise or lower their specific rates in order to stay competitive as the financial markets shift through the natural ups and downs of interest rate fluctuations.
3. Fixed vs. Variable Student Loan Rates:
Loans can be either fixed or variable, and if a loan carries a fixed interest rate then that rate will remain the same throughout the entire lifetime of the loan repayment process. If you take out a student loan that charges a fixed rate of 4%, for instance, then that rate will remain intact for as long as you have the loan – as long as you don’t trigger a rate change by violating the terms and conditions of the loan.
With a variable rate, by contrast, the rate may vary. Your interest rate can go up, come down, or remain the same, depending upon prevailing interest rates. The rate may rise if economic conditions send interest rates higher, for example, or it may fall, which would make your loan less expensive if prevailing conditions send rates lower.
Because of the inherent potential of variable rates to change, you should check to see if the loan has caps or limits placed on high the rate can go during any given time-frame. But these kinds of loans can also potentially work in your favor to trigger lower monthly payments.
That’s because if interest rates fall you’ll capture more savings, whereas with a fixed rate loan even if rates drop, the rate you pay will remain exactly the same.
4. Discounted Interest Rates:
Lenders sometimes also offer discounted interest rates on loans, and they may advertise these using terminology such as “reduced basis points.” Essentially these are marketing incentives offered to borrowers that provide them with especially low, attractive rates on student loans or student loan consolidation and refinancing.
Why would a lender extend that kind of perk to a customer? Typically these incentives are offered to borrowers who agree to have their monthly payments automatically withdrawn from their bank accounts each month.That ensures that the lender gets paid on time, as long as you keep sufficient funds in your bank account.
In exchange for that reassurance, many lenders will agree to give you an interest rate discount. Since the amount of interest you pay has a significant and direct impact upon the size of your monthly payment, these kinds of incentives are yet another factor that can affect your student loan interest rate.
Student loan refinancing is a process where you take out a brand new loan to pay back the loan or loans that you currently owe. This new loan comes with a different interest rate, terms, and options compared to your old loan, so you can negotiate for a lower interest rate altogether.
Ultimately, the goal of student loan refinancing is to get a lower interest rate on your student loans. With a lower interest rate, you may end up paying less, helping you to cut down on the final amount that you owe for your student loans.
How do you Calculate Student Loan?
Once you begin to make payments, the lender will calculate the interest on a monthly basis and add it to your loan amount. Since interest is accumulated continuously rather than in a single sum, student loans have compound interest. Here’s a formula that allows you to calculate your student loan interest at home:
- Let P stand for the outstanding balance on your loan, or the total amount that you have left to pay back.
- Let D stand for the number of days since your last payment.
- Now take your loan’s interest rate and turn that into a decimal (so 6% would become 0.06). Divide that decimal by 365. That will give us R.
- Now multiply these like this: P × D × R
The result will be the amount of interest added to your student loan balance that month. So, for example, if you had an outstanding student loan balance of $40,000 and an interest rate of 6%, here’s how you would calculate the interest compounded on your loan over 30 days.
$40,000 × 30 × (0.06 ÷ 365) = $197.26
How to Reduce the Student Loan Interest You Pay?
Due to the fact that student loan interest charges can add so much to your educational costs, it is a good idea to explore options to reduce your expenses. The following steps can help you save money:
1. Apply for scholarships and grants before you borrow
One of the best things you can do is to apply for grants and scholarships. Unlike student loans, which you have to repay, scholarships and grants are free money that you don’t have to pay back. Plus, you can apply for and receive multiple grants and scholarships, reducing how much you need to borrow in student loans.
Dedicate an hour or two every week to finding grants and scholarships to apply for. You can also meet with your college’s financial aid office to see if there are institutional aid programs for which you qualify.
2. Try to boost your income to pay your loans down faster once you borrow
Besides scholarships, launching a high-paying college side hustle can make a huge difference in reducing your reliance on student loans. And if you’ve already graduated, you can also look into other hustle opportunities that you can do while working full time.
If you apply all the extra income straight to your loans, you can really get ahead on repayment. Our extra payment calculator shows how much of an impact these extra payments made.
3. Refinance your student loans once you’re stable
Once you graduate, refinancing your student loans can be a great option for reducing your interest rates. When you refinance your loans, you can take out a new loan with completely different repayment terms. You could qualify for a loan with a lower interest rate, different repayment period, and even a lower monthly payment.
Refinancing does have some disadvantages to keep in mind. For example, if you refinance federal loans, you’ll lose out on access to IDR plans and loan forgiveness. You also won’t get borrower protections such as the ability to defer loan payments.
But if you’re focused on becoming debt-free as quickly as possible, refinancing with a lower-interest loan can help you pay off your loan ahead of schedule.
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