How To Calculate Student Loan Interest: A Step-by-Step Guide
If you’re like most college students, you probably have a student loan to repay and are wondering how to calculate student loan interest. Luckily, we have prepared a step-by-step guide to help you do just that!
In addition to covering how to calculate interest on a student loan, we’ll also discuss some strategies you can employ to make repaying your student loan easier. Let’s get started.
How Does Student Loan Interest Work?
When you first take out a student loan, the interest rate may seem like a small and unimportant number. After all, what’s a few percentage points when you’re borrowing thousands of dollars?
However, the interest rate on your loan can have a significant impact on the total cost of your education, regardless of whether you’re applying for federal or private student loans.
Here's how it works: The interest rate on your loan is the percentage of the total loan amount you'll have to pay in interest over the life of the loan. As this is simple - not compound - interest we’re talking about, it’s calculated as a percentage of the principal or the original sum of money borrowed or invested.
It’s important to understand how this interest is calculated before you borrow any money. Otherwise, you could end up paying far more than you ever expected. So, let’s see how you can calculate your student loan interest.
Calculating Interest on Student Loans
Student loans are a necessary evil. If you want to go to college but don’t have the money, a student loan might be your only choice. And once you start taking out student loans, the interest starts accruing. But how do lenders calculate it?
Calculating the Daily Interest Rate and Charge
To calculate the daily interest rate on a loan, you need to know the principal amount and the interest rate. The principal is the amount of money you borrowed, and the interest rate is the percentage of that amount you’ll be charged each year.
To calculate interest on a student loan, you need to determine the daily interest rate. You can do that by dividing the annual interest rate by 365 days.
For example, if you have a loan with an annual interest rate of 6%, your daily interest rate would be 0.06 / 365 = 0.000164%. To calculate your daily interest charge, you multiply the daily interest rate by the principal. So, if your principal is $10,000 and the daily interest rate is 0.000164%, you’ll be charged $1.64 in interest each day.
Calculating Your Monthly Payments
Once you know your daily interest charge, you can calculate your monthly interest amount. To do that, just multiply the daily interest charge by 30. In our example, that would be $1.64 x 30 = $49.20.
Now, to calculate your monthly payment, you also need to know your loan term length. Let’s say it’s eight years. That’s 96 monthly payments. When we divide the principal amount by the number of monthly payments, we get $10,000 / 96 = $104.17. Add to that your monthly interest charge of $49.20, and you’ll get $153.37. That’s the sum you’ll need to pay in the first month.
But what about the remaining 95 monthly payments? Well, as you pay off the principal, the interest charged on it will get lower each month, lowering your monthly payment. After the first month, the amount of the outstanding principal will be $10,000 - $104.17 = $9,895,83. You should then use this new amount in your calculations:
$9,895,83 x 0.000164% x 30 + $104.17 = $152.76
You can use the formula above each month to calculate your monthly payment - but only under the condition you don’t skip payments and pay both the interest and the portion of the principal due that month. If you don’t pay interest on your loan as it accrues, you may incur additional costs in the form of interest capitalization.
Interest capitalization is the practice of adding unpaid interest to the principal loan balance. This means that the borrower will end up paying interest on the interest that has accrued, in addition to paying off the original loan amount.
Interest capitalization can have a significant impact on the total cost of a loan, and it’s important to be aware of this practice if you are considering taking out a loan. When interest is capitalized, it’s added to the loan’s principal balance, which can make it difficult to pay off the loan.
That’s why it’s crucial to calculate future interest charges and make sure you can afford the monthly payments before taking out a loan.
If you consider taking out a loan, be sure to ask the lender about their policy on interest capitalization. Some lenders may allow you to make voluntary payments toward the interest that has accrued, which can help keep the total cost of the loan down. Other lenders may require that you make payments toward the accrued interest as part of your regular loan repayments.
Strategies for Paying Off Your Debt
Now that we understand the student loan interest rate calculation, there are a few strategies you may want to consider in case you’re struggling to make your monthly payments on time.
As you can see from our calculation above, each monthly payment goes toward both the principal and the interest. As the total amount of the principal gets smaller, so does the amount of interest paid each month on that principal, resulting in progressively lower monthly student loan installments.
With loan amortization, monthly installments are fixed. Just like with the regular loan repayment plan, each installment goes toward both the principal and the interest. However, with loan amortization, these two elements are balanced out so that the monthly payment stays fixed. At the beginning of the repayment period, a larger portion of each monthly installment is applied to interest, while at the end, the opposite is true.
When you apply for loan amortization, you’re usually given a table that shows how much money will go toward the principal and how much will go toward the interest each month. This table is called an amortization schedule. Besides this, you also can use a student loan simulator to help you out.
Refinancing is the action of taking out a new loan to pay off an existing loan. The new loan usually has different terms than the existing loan. Basically, you get to choose between two options: The interest rate may be lower (but you’ll have to pay off your loan faster), or the repayment period may be longer (but the total amount you’ll end up paying will increase).
The Bottom Line
Student loan interest can be confusing, but now that you know how calculating student loan interest works, it doesn’t have to be so stressful. By following the steps in this article, you can easily calculate the interest you’ll have to pay each month. You can also use strategies like refinancing and amortization to lower your monthly payments or reduce the total cost of your loan.
You may be also interested in:
What is a loan forgiveness program?
A loan forgiveness program is a government plan that forgives student loans for certain borrowers. For example, the Public Service Loan Forgiveness Program forgives federal student loans for borrowers who work in public service. There are also loan forgiveness programs for teachers and nurses.
Can I make extra payments on my student loans?
Once you calculate your student loan payments, you may find that you can afford to make extra payments. Making extra payments can help you pay off your loan faster and save money on interest. Check with your lender to see if there are any restrictions on making extra payments before doing so.
Should I pay off interest or principal first?
It depends on the terms of your loan. Some loans, such as graduated repayment loans, may require you to pay interest first. Other loans, such as income-based repayment plans, may allow you to choose how to apply your payments.
Albert Einstein is said to have identified compound interest as mankind’s greatest invention. That story’s probably apocryphal, but it conveys a deep truth about the power of fiscal policy to change the world along with our daily lives. Civilization became possible only when Sumerians of the Bronze Age invented money. Today, economic issues influence every aspect of daily life. My job at Fortunly is an opportunity to analyze government policies and banking practices, sharing the results of my research in articles that can help you make better, smarter decisions for yourself and your family.