For most college students, loans are a fact of life.
Understanding how student loans work is very important if you’ll need them to pay for your education or if you already have them, and one of the most important topics is interest.
How is Student Loan Interest Calculated?
For most student loans, interest is compounded daily, which means the lender will divide the annual interest rate by the number of days in the year, and then charge that daily interest rate based on your outstanding balance on that day.
Each day, that interest charge is added onto the principal balance, so the next day, the interest charge is slightly higher than previously. This is how compounded interest works; it is continually tacked onto a balance and incorporated into the next interest charge.
For example, assume that you took out a $10,000 loan with a 5 percent annual percentage rate, or APR. If the interest on this loan were only compounded annually — rather than daily — then interest would be $500 per year assuming you made no payments to your loan. This is the simplest way to understand interest, but it doesn’t work that way unfortunately.
With that 5 percent APR being compounded daily, interest is charged at a rate of .00136 percent each day. Using a standard compound interest formula and assuming no payments were made throughout the year, about $513 of interest would accrue compared to only $500 in the first example.
While this system may be annoying to the borrower, it is actually a necessity for the lender. In the first example, a borrower could theoretically pay the entire loan within a year. The lender would not be able to make any money off the interest charges if interest was compounded annually because the balance would be $0.
How Often Does Interest Accrue on a Student Loan?
As mentioned earlier, interest on a student loan is compounded on a daily basis, which can make it challenging to pay off your student loans. While you are not required to make payments on your student loans during school, interest will start to accrue as soon as your loan is disbursed.
After graduation, this interest will then be capitalized (capitalized is the same as compounded). Most lenders give borrowers a six-month grace period after graduation before they are required to make their first student loan payment. At the end of this grace period, the accrued interest is capitalized and added to the principal owed.
However, you can avoid the capitalization of interest by making interest-only payments on your student loans while you are still enrolled in college or graduate school, or during the grace period. While it will require some sacrifice, it can help ensure that your loan is manageable once you are making payments on it after graduation.
Author: Jeff Gitlen
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