All federal student loans and most private student loans have simple interest. With simple interest, borrowers pay interest only on the principal of the loan.
Loans with compound interest charge interest on the principal and on unpaid interest. This makes them more expensive than simple interest loans.
It’s important to understand how the interest on your student loans is calculated so that you know what you’re paying over the course of your loan term.
Understanding Simple and Compound Interest
The interest you pay on a student loan is the cost of borrowing the money. Here’s how simple vs. compound interest works.
Simple Interest Explained
Simple interest means you pay interest only on the principal balance. You do not accrue interest on any unpaid interest.
Simple interest is calculated using this formula: Principal x Interest Rate x Loan Term.
Compound Interest Defined
With compound interest, you pay more interest over time. The lender charges interest on your loan balance plus the unpaid interest that accrues.
How much compound interest you’ll pay depends on the number of compounding periods your loan has. The more compounding periods, the more the compound interest amount will be.
For example, if your loan compounds daily, the daily interest rate is applied to the principal along with any unpaid interest up until that point.
Over the life of the loan, compound interest will cost a borrower more.
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How Student Loan Interest Works
The way student loan interest works depends on the type of loan you have.
Federal Student Loan Interest
Federal student loans, which are backed by the U.S. Department of Education, have fixed interest rates, which means the interest rate never changes. While the interest on these loans begins accruing immediately, how the interest is handled depends on the type of loan you have.
With Federal Direct Subsidized loans, which are awarded based on financial need, borrowers do not pay interest while they are in school, during a six-month grace period after graduation, or during any deferment period. The government covers the interest payments during these times.
Direct Unsubsidized loans, which are not awarded based on financial need, work differently. Borrowers are responsible for paying the interest on these loans at all times. If they don’t pay the interest while they are in school, during the six-month grace period after graduation, or in times of student loan deferment, the interest will accrue and be added to the principal of the loan.
All Federal Direct loans are “daily interest” loans, which means interest adds up each day.
Private Student Loan Interest
Private student loans are offered by private lenders such as banks, credit unions, and online lenders. These loans may have either a fixed or variable interest rate.
The interest rates for private student loans are determined by the lender and are based largely on the borrower’s credit score and income.
Many private loans have simple interest, however, some use compound interest. Before taking out a loan, find what type of interest it has. This is one way to help manage student loan debt.
Check out our private student loan guide to learn more about how the interest works on these student loans.
Capitalization of Interest
When interest capitalizes, the unpaid interest is added to the principal amount of the student loan. This increases your loan’s principal balance, and interest is charged on the new, larger balance.
For instance, capitalization may happen during periods of deferment if you have Direct Unsubsidized loans. In that case, the interest may be added to the principal amount of the loan. This might increase your monthly payment and the overall cost of the loan.
Calculating Interest Costs on Student Loans
To calculate interest costs on student loans, first find out what kind of interest the loan has. In most cases, it will be simple interest. As discussed, all federal student loans and many private student loans have simple interest.
To determine how much the monthly simple interest would be, you first need to find out what the daily interest on the loan is. To calculate that, divide the interest rate by 365 and multiply that number by the principal amount.
For a $10,000 loan with a 6.00% interest rate, the calculation would look like this:
0.06/365 x 10,000 = $1.64
You’re paying $1.64 in daily interest. If your billing cycle is 30 days, multiply 1.64 x 30 = 49. That means you’re paying $49 a month in simple interest.
If the student loan has compound interest, the calculation is more complicated. As mentioned, the amount of compound interest you’ll pay depends on the number of compounding periods your loan has. For example, if your loan compounds daily, the interest rate is applied each day to the principal along with any unpaid interest up until that point.
So if your loan is $10,000 and your daily interest amount is $1.64, the next day, that interest is added to the principal and you’re charged interest on the new, higher amount of $10,001.64. The interest charges will continue to increase this way each day.
A student loan with compound interest can end up costing you more and result in your living with student loan debt over the long term.
Strategies to Minimize Student Loan Interest
Fortunately, there are ways to minimize student loan interest. Here are some steps that can help.
Making Interest-Only Payments
If you have Federal Direct Unsubsidized student loans or private student loans, making interest-only payments while you’re in school could save you money. These payments will help keep the interest from accruing and being added to your principal.
Refinancing for Lower Rates
When you refinance student loans, you take out a new private loan to cover the cost of your current loans. Refinancing may allow you to get a lower interest rate or better loan terms and help you simplify your loan payments. Using a student loan refinancing calculator can help you determine if you could benefit from refinancing.
It’s possible to refinance private and federal student loans. However, it’s important to note that if you refinance federal loans with a private lender you will no longer have access to federal programs and protections like income-driven repayment plans.
Paying Off High-Interest Loans First
Paying off your loans with the highest interest first could help you save you money over the long term because you’re paying off your costliest debt. To do it, make payments on all your loans when they’re due, but put any extra money you have toward the highest-interest loan.
After you pay off that loan, tackle the next-highest interest loan, and so on until your debt is paid off. This is commonly called the debt avalanche method of paying off debt.
Tax Implications of Student Loan Interest
It’s possible to get a tax deduction for the interest you pay on student loans. This is known as the student loan interest deduction and it allows you to potentially deduct up to $2,500, or the amount of interest you paid on your federal or private student loans — whichever amount is less — from your taxable income.
There are income phaseouts to this deduction based on your modified adjusted gross income (MAGI). Your MAGI must be below a certain limit, which typically changes each year, in order to claim the deduction.
The Takeaway
The interest on most student loans is simple interest and not compound interest. All federal student loans have simple interest and many private loans do as well.
Before you take out a student loan, make sure you understand what kind of interest it has and how the interest accrues. Depending on the type of loan it is, you may want to make interest payments while you’re in school to help manage your debt.
Refinancing your student loans may also be worth considering if you can qualify for a lower interest rate or better terms. You can shop around with different lenders for the best rates and terms for your situation.
Looking to lower your monthly student loan payment? Refinancing may be one way to do it — by extending your loan term, getting a lower interest rate than what you currently have, or both. (Please note that refinancing federal loans makes them ineligible for federal forgiveness and protections. Also, lengthening your loan term may mean paying more in interest over the life of the loan.) SoFi student loan refinancing offers flexible terms that fit your budget.
FAQ
Do federal student loans have simple or compound interest?
Federal student loans typically have simple interest, which is interest calculated only on the amount of money you borrowed (the loan principal). Many private student loans use simple interest as well, but some private student loans do use compound interest, in which interest is charged on your loan balance and on the unpaid interest that accrues.
Which type of interest is more expensive for borrowers?
Compound interest is more expensive than simple interest is for borrowers. That’s because compound interest is calculated on the accumulated interest as well as on your original principal. With compound interest, you end up paying more over time.
Can interest be deferred on student loans?
When you defer Direct subsidized federal student loans, the interest is deferred. However, interest continues to accrue on unsubsidized federal student loans during a deferment, and the unpaid interest will be capitalized and added to your loan principal when the deferment ends.
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