How Student Loan Interest Works

I seem to receive a lot of questions around how interest works on student loans as well as how it is calculated. I’ve also seen a lot of confusion in general across the internet when it comes to student loan interest. I think it’s important to understand how much of your money is going to interest or how much you are saving on interest by making extra payments. On large loan balances interest can really eat into the progress you are making, so it’s important to understand what is actually going on. I’m hoping that this post can clear up some of the common misconceptions, and hopefully it will also be able to help you calculate on your student loans easily.

The first step to calculating how much money is going towards interest is to actually look up your interest rate. This should be clearly displayed either on your paper bill for your loans or when you login to your servicers website. Let’s use the example of a $25,000 loan balance with a 6.5% interest rate. To calculate how much interest you are going to pay in an entire year, you simple multiply your loan balance by the interest rate.

$25,000 loan balance * 6.5% interest rate (.065) = $1625 interest paid each year

So the amount of interest you will pay in a year is $1625, if you were to make no payments throughout the year. Student loan interest accrues daily (simple daily interest), so as soon as you make a payment your balance will decrease. The next calculation of your student loan would already been on a lower balance! So every payment you are making that decreases your loan balance, you are saving a little more on interest.

If you want a quick estimate of how much interest is being added to your loan, you can take the $1625 amount from the above and divide by 365.

$1625 interest paid each year / 365 days = $4.45 interest accrues daily

So you see how important it is to start making payments and reducing your principal as quickly as possible. Just by having this loan outstanding, you are losing an extra $4.45 a day. But every extra payment you make can decrease this amount.

There is also another way to calculate your interest if you didn’t like the first method that I use. This works by finding your interest rate factor. This is done by dividing your loans interest rate by the number of days in a year (365).

6.5% interest rate (.065) / 365 = 0.000178 interest rate factor

We can then use that interest factor to determine how much interest will accrue over however many days you’d like to calculate.

$25,000 loan balance * 1 day * 0.000178 interest rate factor = $4.45 interest in one day

You see that we ended up with the same exact result as our first calculation, it’s just a different way to go about it. Since you are most likely making monthly payments, this is a good way to verify the amount of interest that is accruing each month as well.

$25,000 loan balance * 30 days * 0.000178 interest rate factor = $133.50 interest in 30 days

I hope that these formulas can help you calculate based on your own student loan balances and interest rates, and helps you get a clearer picture of where your money is going. I know that seeing the actual numbers is what helps me the most. If you have any questions about calculating it yourself or if you need help, don’t hesitate to post in the comments or ask me. Hope this helps some people!

Image Source: Death to Stock

Join the Conversation

3 Comments

Leave a comment

Your email address will not be published. Required fields are marked *

This site uses Akismet to reduce spam. Learn how your comment data is processed.