Does Student Loan Interest Compound? Yes, Here's When

Federal student loan interest and many private student loan interest accrue daily and compound monthly. But specific loan terms may vary, so you’ll need to review the loan agreement for exact compounding frequency.

Although understanding whether student loan interest compounds is essential, there’s more to know to avoid costly mistakes in managing your student loan debt.

Ahead, we’ll dive deeper into student loan interest, different loan types, interest calculation methods, and provide valuable tips to help you tackle your debt efficiently and achieve financial freedom.

Get a grasp on the fundamentals of student loan interest rates to effectively manage your student loan debt. Interest rates can be fixed or variable, differing between federal and private student loans. We’ll dive into how both types of loans determine interest rates and the impact of credit scores.

Fixed and variable interest rates

Student loans have a fixed or variable annual percentage rate (APR). Fixed APRs stay constant for the loan’s duration, but variable APRs change based on fluctuations in a reference interest rate, like the prime rate or LIBOR.

Federal student loan interest rates: Fixed and Predictable

Federal student loan interest rates are fixed, so they don’t change during the loan’s life. Congress sets these rates yearly, based on the high yield of the last 10-year Treasury note auction in May. New rates apply to loans disbursed from July 1 to June 30 the following year.

Keep in mind that your credit score or financial history doesn’t determine federal student loan interest rates. Instead, all qualified borrowers receive the same interest rate for a specific loan type.

Private student loan interest rates: Creditworthiness matters

Private student loan interest rates can be fixed or variable depending on the lender and loan product. Unlike federal loans, private lenders determine interest rates based on market conditions and the creditworthiness of the borrower and cosigner. Rates can vary greatly between lenders and borrowers, with higher credit scores and stronger financial histories generally leading to lower interest rates.

Before diving into specifics, let’s grasp the basics of how interest is calculated on a student loan.

Interest is the cost of borrowing money and is typically expressed as a percentage of the loan principal. For example, if you have a $10,000 loan with a 5% annual interest rate, you’ll accrue $500 in interest over one year.

While that’s simple enough, student loans are complicated, and how interest accrues, and compounds can vary between federal and private student loans.

When does student loan interest start accruing?

Interest accrues on student loans at various times, depending on the loan type.

Here’s a quick rundown of when student loan interest starts accruing for different loans:

• Direct Subsidized Loans (Undergraduate): Interest accrues six months after graduation, provided you’re enrolled at least half-time. The fixed interest rate is 4.99% (as of January 2023).

• Direct Unsubsidized Loans (Undergraduate): Interest accrues upon loan disbursement. The fixed interest rate is 4.99% (as of January 2023).

• Direct Unsubsidized Loans (Graduate or Professional): Interest accrues upon loan disbursement. The fixed interest rate is 6.54% (as of January 2023).

• Direct PLUS Loans (Parents and Graduate or Professional Students): Interest accrues upon loan disbursement. The fixed interest rate is 7.54% (as of January 2023).

Private student loans and direct unsubsidized loans: Interest accrues from disbursement

Interest accrues upon disbursement for private student loans and federal Direct Unsubsidized Loans. If you don’t make interest payments while in school, interest will build up throughout your college years.

Direct subsidized loans: Interest-free periods

For federal Direct Subsidized Loans, the government covers your accrued interest while in school and during a six-month grace period after graduation. After this grace period, you’ll be responsible for repaying the principal and the interest.

Student loan interest is calculated using either simple interest or compound interest. Here’s a breakdown of the two methods:

Simple Interest: Based on Principal Amount

Simple interest calculates interest charges based only on the principal amount. To compute monthly simple interest, multiply three factors: the daily interest rate, the principal (loan balance), and the number of days between payments.

The simple interest formula charges interest only on the principal, so the daily interest cost remains consistent throughout the payment period. For example, if your interest cost is $3 a day with a monthly billing cycle, your monthly interest is $90.

Each month’s payment covers the full interest amount owed for that month.

Compound interest: Paying interest on interest

With compound-interest loans, you’re always paying interest on your interest. In other words, the daily interest rate is applied to the current loan amount plus any unpaid interest up to that moment. If your loan compounds interest daily, each day’s unpaid interest is added to your principal balance.

For example, suppose your loan’s principal balance is $10,000, and the daily interest cost is $3.

On the first day, your interest cost is $3, and your loan balance becomes $10,003.

On the second day, interest is calculated on the new balance, resulting in a slightly higher daily interest cost.

This process continues throughout the loan repayment period, causing the interest cost to increase over time as the unpaid interest is added to the principal balance.

No, federal student loan interest doesn’t compound daily.

Instead, federal student loans like Direct Subsidized Loans, Direct Unsubsidized Loans, FFEL Loans, and Perkins Loans use a simple daily interest formula.

This means interest is calculated daily based on the outstanding principal balance but doesn’t compound or build up daily.

How often is interest calculated?

Federal student loan interest is calculated daily, but it’s essential to note that the interest doesn’t compound or accumulate monthly. Instead, interest accrues daily, adding up over time.

Private student loans may have different interest calculation methods depending on the lender. Some private loans accrue simple interest, while others may compound interest. Reading your promissory note and understanding how interest is calculated for your specific loan is crucial.

When does federal student loan interest compound?

While federal student loan interest doesn’t compound daily or monthly, unpaid interest may be capitalized (added to the principal balance) under specific circumstances.

Capitalization events can include:

• Entering repayment after a grace period.

• Changing repayment plans.

• Leaving an income-driven repayment plan.

When interest capitalizes, it effectively compounds, forcing you to pay interest on the increased principal balance.

Most student loans, particularly federal ones, feature simple interest, meaning the interest is generally not compounded. But there are exceptions, such as during deferment periods or under certain income-driven repayment plans, where interest can be capitalized or effectively compounded. Some private student loans might use a daily compound interest formula. In summary, student loan interest is most commonly simple but can be compounded daily or monthly depending on the loan terms.

To illustrate the difference between simple daily interest and compound interest, let’s consider two examples.

Example 1 – Simple Daily Interest. You have a $10,000 loan with a 5% annual interest rate. The daily interest rate would be 0.05 / 365 = 0.000137.

• Over one day, you would accrue $1.37 in interest ($10,000 x 0.000137).

• Over 30 days, you would accrue $41.10 in interest ($1.37 x 30).

• Over one year (365 days), you would accrue $500 in interest ($1.37 x 365).

Example 2 – Compound Interest. With the same $10,000 loan and 5% annual interest rate, let’s assume interest compounds daily. The daily interest rate would still be 0.000137.

• On the first day, you would accrue $1.37 in interest.

• On the second day, you would accrue interest on the new balance of $10,001.37, resulting in $1.37019 in interest.

• This process continues for 30 days, and by the end of the month, you will accrue about $41.34 in interest.

• Over one year, you would accrue about $512.67 in interest.

Simple daily interest vs compound interest compared

Comparing the two examples, it’s clear that compound interest results in a higher interest charge over time.

Here, compound interest accrued over 30 days amounts to $41.34. Over one year, it’s $512.67.

On the other hand, simple daily interest accrued over 30 days is $41.10, and over one year, it’s $500.

Although the difference might appear small in the short term, it can accumulate significantly over the life of the loan.

1. Make Extra Payments

Paying extra on your student loans helps you save money and pay them off faster. Extra payments lower the principal balance, which reduces interest over time. Pay more frequently, such as weekly or bi-weekly, to decrease the principal balance even quicker.

2. Strategic Payments

When making extra payments, request that they go directly to the principal balance. This way, you save more money on interest. Check with your loan servicer on how to do this correctly.

3. Choose Between Debt Snowball and Debt Avalanche

The debt snowball method pays off loans from smallest to largest balance, while the debt avalanche method targets the highest interest rates first. Pick the best strategy for you based on your goals and preferences.

4. Refinance Student Loans

Student loan refinancing can save money and simplify repayment. You might get a lower interest rate, consolidate multiple loans, and choose a new repayment term. However, refinancing federal loans with a private lender means losing federal benefits like flexible repayment options, deferments, forbearances, and access to student loan forgiveness programs.

5. Explore Loan Forgiveness Programs

The federal government offers various programs that will eliminate your loan balance if you work in public service, make payments for at least two decades, teach in low-income neighborhoods, become totally and permanently disabled, and more. Check eligibility and application requirements on StudentAid.gov.

6. Switch to an Income-Driven Repayment Plan

The Department of Education offers different income-based repayment options that tie your monthly payment to your income and family size. IDR plans can make your federal student loan payments more affordable and lead to loan forgiveness, but you may owe taxes on the forgiven amount.

But be cautious.

Your monthly payment amount may sometimes be less than the amount of interest that accrues on your loans. This will result in negative amortization under current IDR Plans. But that’ll change once Biden’s new income-based repayment plan is released this summer.

Paying off student loans can be daunting, but various strategies can help you tackle your debt more efficiently.

Understanding how student loan interest works, making extra payments, refinancing your loans, considering loan forgiveness programs, exploring income-driven repayment plans, and using the debt snowball or debt avalanche strategies can all contribute to paying off your student loans faster.

Assess your financial situation and choose the methods that best align with your goals and circumstances.

With persistence and a well-planned strategy, you can successfully repay your student loan debt and achieve financial freedom.