Compound interest can add up a lot to what you pay in student loan fees over time, adding thousands of dollars to the initial loan amount. Simple interest is applied to most student loans, but it is necessary that borrowers with certain private loans or who find themselves in certain repayment scenarios comprehend compound interest. This will assist you in making better choices about your education financing and building sound repayment strategies.
Simple vs. compound interest on student loans
Most student loans, all federal student loans and most private loans, use simple interest rules. With simple interest, the lender only charges interest on your original loan amount using the formula: Principal × Interest Rate × Loan Term. This simple method means you only pay interest on the money you borrowed in the first place.
Compound interest, on the other hand, operates differently. Compound interest loans charge interest on your original principal as well as on any unpaid interest already accumulated. This causes a snowball effect in which interest begets more interest, greatly amplifying your overall repayment cost over time. A few private student loans use this compound interest formula, making them much more costly in the long term.
How compound interest calculations work
There are numerous variables involved in calculating compound interest, and the frequency of compounding is an especially significant factor. The more often interest compounds (daily, monthly, quarterly), the greater the overall interest fees will be.
For the daily compounding loan, the lender adds your principal, as well as any unpaid interest accrued to date, to the daily rate of interest. The easy formula for daily interest is:
[Noteworthy principal amount × rate factor of interest] × days that have passed since last payment
With compound interest, your unpaid interest is added to your principal each day, creating a new, larger balance on which the next day’s interest is charged. For example, suppose you have $30,000 due on a loan and are charged $3 in interest the first day. The second day, you’re charged interest on $30,003, and this continues, with interest charges compounding higher each day until your next payment.
The compounding effect on loan balances
Compound interest increases the effect over time. While a simple interest loan maintains the daily cost of interest constant for the payment duration, compound interest establishes an increasing growth cycle. This disparity especially matters when there are periods of non-payment or less-than-full payments.
To illustrate: On a simple interest loan that charges $3 a day for a 30-day billing cycle, your monthly interest would be $90. But on a compound interest loan, each day’s interest is added to your principal, so your balance and daily interest charge increase incrementally. At the end of the month, your interest charges would be greater than $90 and increasing faster and faster with each passing day.
When simple interest loans behave like compound loans
Even federal student loans with simple interest can exhibit compounding effects under certain circumstances. Compounding effects occur when unpaid interest is capitalized to your principal balance, effectively creating a compound interest situation. This typically happens during:
- Forbearance periods
- Loan consolidation
- Switching from deferment into repayment
- Switching repayment plans
When interest has been added up, your new principal will be equal to the original amount plus accrued interest, and future interest computations are based on the higher figure.
Techniques for minimizing compound interest effect
In order to minimize compound interest impact on your student loan balance:
- Make payments throughout schooling whenever feasible, though not required
- Pay accruing minimum interest during times of forbearance
- Pay more often than necessary (bi-weekly rather than monthly)
- Make payments exceeding the minimum payment threshold
- Refinance compound interest private loans with high interest to simple interest loan characteristics
Knowing how compound interest on your student loan balance works is the first step to smart financial planning. Federal loans operate with simple interest, but other private loans and certain circumstances initiate compound interest forces that balloon your total repayment burden exponentially. Being informed about how the interest compounds on your personal loans and employing strategic payment strategies allows you to buffer these forces and save thousands of dollars in the long run.
Read more: What happens to my student loans if I become permanently disabled?
