If you’ve recently graduated or left college, you might be surprised at how much of your student loan payment goes just to the interest portion of your debt. To understand why that is, you first need to understand how that interest accrues and how it’s applied toward each payment.

Key Takeaways

• Federal loans use a simple interest formula to calculate your finance charges; however, some private loans use compound interest, which increases your interest charges.

• Some private student loans have variable interest rates, which means you may pay more or less interest at a future date.

• Except for subsidized federal loans, interest generally starts accruing when the loan is disbursed.

3 Steps to Calculate Your Student Loan Interest

Figuring out how lenders charge interest for a given billing cycle is actually fairly simple. All you have to do is follow these three steps:

Step 1. Calculate the daily interest rate

You first take the annual interest rate on your loan and divide it by 365 to determine the amount of interest that accrues on a daily basis.

Say you owe $10,000 on a loan with 5% annual interest. You’d divide that rate by 365 (0.05 ÷ 365) to arrive at a daily interest rate of 0.000137.

Step 2. Identify your daily interest charge

You’d then multiply your daily interest rate in Step 1 by your outstanding principal of $10,000 (0.000137 x $10,000) to figure out how much interest you’re assessed each day. In this case, you’re being charged $1.37 in interest on a daily basis.

Step 3. Convert it into a monthly amount

Lastly, you’ll have to multiply that daily interest amount by the number of days in your billing cycle. In this case, we’ll assume a 30-day cycle, so the amount of interest you’d pay for the month is $41.10 ($1.37 x 30). The total for a year would be $493.20.

When Does Interest Accrue?

Interest starts accumulating like this from the moment your loan is disbursed, unless you have a subsidized federal loan. In that case, you’re not charged interest until after the end of your grace period, which lasts for six months after you leave school.

With unsubsidized loans, you can choose to pay off any accrued interest while you’re still in school. Otherwise, the accumulated interest is capitalized, or added to the principal amount, after graduation.

If you request and are granted a forbearance—basically, a pause on repaying your loan, usually for about 12 months—keep in mind that even though your payments may stop while you’re in forbearance, the interest will continue to accrue during that period and ultimately will be tacked onto your principal amount. If you suffer an economic hardship (which includes being unemployed) and enter into deferment, interest continues to accrue only if you have an unsubsidized or PLUS loan from the government.

Simple vs. Compound Interest

The calculation above shows how to figure out interest payments based on what’s known as a simple daily interest formula; this is the way the U.S. Department of Education does it on federal student loans. With this method, you pay interest as a percentage of the principal balance only.

However, some private loans use compound interest, which means that the daily interest isn’t being multiplied by the principal amount at the beginning of the billing cycle—it’s being multiplied by the outstanding principal plus any unpaid interest that's accrued.

So on Day 2 of the billing cycle, you’re not applying the daily interest rate—0.000137, in our case—to the $10,000 of principal with which you started the month. You’re multiplying the daily rate by the principal and the amount of interest that accrued the previous day: $1.37. It works out well for the banks because, as you can imagine, they’re collecting more interest when they compound it this way.

The above calculator also assumes a fixed interest over the life of the loan, which you’d have with a federal loan. However, some private loans come with variable rates, which can go up or down based on market conditions. To determine your monthly interest payment for a given month, you’d have to use the current rate you’re being charged on the loan.

Some private loans use compound interest, which means that the daily interest rate is multiplied by the initial principal amount for the month plus any unpaid interest charges that have accrued.

About Amortization

If you have a fixed-rate loan—whether through the federal Direct Loan program or a private lender—you may notice that your total payment remains unchanged, even though the outstanding principal, and thus the interest charge, are going down from one month to the next.

That’s because these lenders amortize, or spread the payments evenly through the repayment period. While the interest portion of the bill keeps going down, the amount of principal you pay down each month goes up by a corresponding amount. Consequently, the overall bill stays the same.

The government offers a number of income-driven repayment options that are designed to reduce payment amounts early on and gradually increase them as your wages increase. Early on, you may find that you’re not paying enough on your loan to cover the amount of interest that’s accumulated during the month. This is what’s known as “negative amortization.”

With some plans, the government will pay all, or at least some, of the accrued interest that’s not being covered. However, with the income-contingent repayment (ICR) plan, the unpaid interest gets tacked onto the principal amount every year (though it stops being capitalized when your outstanding loan balance is 10% higher than your original loan amount).

The Bottom Line

Figuring out how much you owe in interest on your student loan is a simple process—at least if you have a standard repayment plan and a fixed rate of interest. If you’re interested in lowering your total interest payments over the course of the loan, you can always check with your loan servicer to see how different repayment plans will affect your costs.