Here’s Exactly How Student Loan Interest Works

Back when you signed the dotted line and took out your student loans, how well did you understand the terms? Maybe things were a little fuzzy, but you knew you needed the loans to pay for college.

Student loan interest is one of the more complicated aspects of student loans. How interest rates are set, how interest accrues, and how payments are divided between your principal balance and interest charges can be difficult to grasp.

But understanding how student loan interest works is an important step in managing your debt.

How does student loan interest work?

When new student loans are issued, the borrower signs a promissory note that explains the terms of the loan. Every part of this document is important to read and understand, as it determines how much you owe and when your payments are due.

The most important terms to look out for are:

  • Issue date: The date your loan starts to accrue interest
  • Amount borrowed: The total amount borrowed in each loan
  • Interest rate: How much you have to pay to borrow the funds
  • How interest accrues: Whether interest is charged daily or monthly
  • First payment date: When you have to make your first loan payment
  • Payment schedule: How many payments you have to make

Lenders understand that most full-time students do not have an income, and if they do, it is not enough to cover student loan payments while in school. Because of that, many student loans are subsidized by the federal government. That means you do not accrue interest while still in school.

Unsubsidized loans, meanwhile, charge interest from the day the loan is issued.

Why is this important? Knowing whether your loans are subsidized or unsubsidized tells you if your balances will grow while you’re in school.

How is student loan interest calculated?

Your required loan payment will be the same each month. However, when you make a payment, interest is paid first. The remainder of your payment is applied to your principal balance.

Student loan interest is typically compounded daily. That means your interest rate is divided by the number of days in the year and you are charged each day based on the outstanding balance.

To understand how compound interest works, let’s look at an example. Consider a Direct loan with a $10,000 balance and a 4.29% interest rate.

If this loan were compounded annually, 4.29% of the loan balance would be charged each year. In this case, the interest would be $429 per year.

If your loan compounds daily, you’ll instead be charged interest every day. Your 4.29% interest rate will be divided by 365. That comes out to 0.0118% of interest each day. Assuming a $10,000 balance, that is $1.175 per day.

If you make your payment on the regular schedule once per month, the interest you accrued over the month is added up. Your payment is applied to that accrued interest, which comes out to about $35 in our example. The rest of your payment lowers your outstanding principal balance.

How is student loan interest applied?

As you make payments on your student loan, your balance and the amount of interest you accrue will drop. With lower interest charges, more of your payments are applied to your principal. Over the life of your loan, your interest paid will decline each month, which accelerates your principal payment. That’s how amortization works.

Remember, interest is always paid first. If you have an unsubsidized loan or are past the subsidy period, your loan payoff date requires you to make the same minimum payment each month. If you are on a payment plan or have deferred payments, interest will continue to accrue. This amount is added to your principal, increasing your student loan balance.

If you are able, you should always pay at least the interest each month. If you don’t, your loan balance will continue to grow and you will owe interest on the interest you didn’t pay in previous months.

Further, making partial payments will count as a missed or late payment on your credit report and may cause you to go into loan default, which is not a good thing.

If you are struggling to make payments and can’t figure out a way to afford them, you can look into an income-driven repayment plan. The REPAYE program, for example, limits your payments to 10 percent of your discretionary income.

This loan payment calculator can quickly tell you how much of your payments are going toward interest and principal each year.

How are extra student loan payments treated?

When you make your monthly payment, you are given the option to pay extra. If you do, that extra payment is applied directly to the principal, which will reduce your interest in the future.

Any other extra payments made throughout the month are treated as normal payments. That is, your payment is first applied to interest you accrued since your last payment and then your principal.

Don’t underestimate the power of early payments. Paying an extra $50 or $100 each month can save you thousands of dollars in interest depending on your loan terms. Check out the student loan prepayment calculator to see how much you can save by paying a little more every month.

When I was still making student loan payments, I lived on a budget that allowed me to make a full payment each payday. Paying double each month helped me pay down my balances quickly, and I was able to make my final payment exactly two years and six days after graduation.

Compound interest is a powerful weapon

As some believe Albert Einstein once said, “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”

Putting off payments or just making the minimum each month will leave you with a big interest cost over the life of your loan.

Use your new knowledge of compound interest to pay off your loans early. You work hard for each paycheck. Pay more today so you can save big later.

Get your student loan interest quickstart guide PDF

The article Here’s Exactly How Student Loan Interest Works originally appeared on

How I Paid Off My $90,000 MBA 736 Days After Graduation

On March 10, 2010, I went to the academic hooding ceremony recognizing the completion of my MBA at the University of Denver.

Getting an MBA from a private university is an expensive undertaking. When I started working on my degree, the estimated cost of attendance for the entire program was $91,994. Tuition alone was $67,000.

Even so, a little over two years after graduation – 736 days to be exact – I made my final student loan payment. Here’s how I made it happen and how you can follow in my footsteps to pay off your student loans in just a few years.

Get started on the right footing

I come from a very academically focused family. I always knew I wanted to follow in my grandfather’s footsteps and get an MBA at an early age. My grandpa managed to graduate from Georgia Tech with an undergraduate degree at 19 and got his MBA a few years later, so I had some tough shoes to fill.

I completed my undergraduate program at the University of Colorado debt-free thanks to a full scholarship from the Boy Scouts. I then went on to began my career in banking a couple of months later.

Like many millennials looking to save money after graduation, I moved back in with my parents and started saving thousands of dollars each month. After all, my only expenses at that point were my car, a new grown-up wardrobe, andnights out on the town with friends.

It didn’t take long to realize that I was not in the right job for me, so left the company after about six months to work on something new. At that point, I had saved the majority of my salary for half a year, which left me with the biggest bank balance of my life.

Working during school

When I left the bank, I started looking for finance jobs in different industries. I also decided it was time to start working on that MBA.

I studied hard and rocked the GMAT, gathered my transcripts, and started applying for MBA programs at the same time I was applying for jobs. I also worked as a restaurant waiter for a few months to keep the cash coming in while looking for something new.

I decided at that point that I was going to work full-time while getting my MBA full-time. Crazy? Maybe. Hard work ahead? Definitely.

Shortly after getting accepting to my top choice MBA program, I got a call back from a big telecommunications company I had applied to. A week later, I had a job offer as a financial analyst.

I made it very clear during my interview that I was going to get the MBA, and wanted to work out a way to get the MBA full-time while working full-time. There were no surprises when I showed up on day one with an MBA start date just six months away.

I worked out a deal with my boss that I would get all of my work done – putting in time from home on evenings and weekends if necessary – and in exchange could leave early when needed for my evening class schedule.

When I started working on my MBA that September, it hit me how hard this was really going to be. However, I knew I could do it if I put my mind to it. I started the journey ahead and made my first MBA tuition payment from a combination of student loans, savings, and income from the day job.

Making student loan payments during school

I received a combination of subsidized and unsubsidized Stafford loans to help pay for my MBA program, which added up to about $40,000 in total. The subsidized loans didn’t accrue any interest while I was still in school, but the unsubsidized portion started accruing interest right away. I did not want to see those balances grow while I was still in school.

I moved into off-campus housing a month before school started, but knew I had a huge expense in my near future. I found a place with a roommate for $400 per month and kept myself on a strict budget while in school, using anonline expense tracker to keep me focused.

I started making student loan payments the month my first loan was issued. Even though no payments were due for over a year and a half, I started making payments around $250 per month to chip away at the loan balances during school.

Laser focus on debt repayment

When I graduated with my MBA, I had a big number in front of me and my subsidy period was ending for the subsidized portion of my loans. With a 6.8% fixed interest rate, I wanted to get my loans paid off as quickly as I could to save thousands of dollars in interest.

I stayed in an inexpensive apartment, with rent just under $700 per month, and held other expenses as low as I could. I increased my payments as well. Rather than making the minimum payment each month, I paid it each payday for double the minimum payment each month.

In addition, every time I had a cash windfall, such as a tax refund or bonus at work, I put 100 percent of that into my loans. In my case, that led to an extra $5,000-$10,000 per year.

With a payoff strategy like that, I was destined to be debt-free in under five years. But that wasn’t good enough for me. Did I mention I hate paying interest?

While keeping my budget low, I watched my checking account balance slowly climb each month. After putting away a modest emergency fund, I started putting everything left over each month into the student loans as an extra payment. Even after rent, utilities, car expenses, and bar tabs, I had at least a few hundred dollars left over each month, which all went into the loans.

The final payoff

Two years later, I found my balance was sitting around $3,700. If I dipped a little bit into my emergency fund (maybe not the best idea in hindsight) and put all of my next paycheck to my loans, I could pay it all off on my next payday.

So I did.

pay off student loans

There is one big downside to this story: if my pay day had been a week earlier, I could have called this article, “How I Paid Off My Student Loans in Less Than Two Years.” However, two years and six days is what it took.

Wherever you are on your student loan journey, do not look at this as something “I can’t do.” Yes, I do have a couple of fancy finance degrees, but there is no reason you can’t do the same thing I did.

Work on growing your income, managing your budget, and putting every cent into extra student loans payments that you can. If you do, you may just find yourself looking at a balance that you can pay off on your next pay day.

Every dollar counts and paying off your loans all starts with the next dollar. Don’t believe me? Enter your information into this student loan payoff calculator to see how soon you can be debt-free.


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