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How Does Interest Work on Student Loans?

how does accrued interest work

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Federal student loans can help you become one of the millions of people who pursue post-high school education every year. The interest rates and repayment terms are designed to fit the needs of students. However, borrowing money isn't free. Student loans must be repaid with interest after you leave school.

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Subsidized vs. Unsubsidized Student Loans

Some federal student loans are subsidized, while others are not. This matters because interest works somewhat differently depending on the type of loan.

  • Direct Subsidized Loans are open to undergraduate students. No interest is charged while you attend school or during a period in which loan payments are deferred. Interest accrues only when you start repaying a subsidized loans.
  • There are several types of unsubsidized federal student loans. Direct Unsubsidized Loans, Perkins loans and Direct PLUS loans do not have to be repaid until after you leave school. However, you are charged interest while attending a post-secondary school. You can pay the interest as it is charged or let it accrue. If you don't pay interest, it is capitalized. This means

    it is added to the balance of the loan, increasing the amount you owe.

Calculating Student Loan Interest

Regardless of the loan type, interest on student loans is calculated the same way. Multiply the number of days in a billing period by an interest factor, and then by the outstanding balance of the loan. The interest factor is the daily rate of interest, determined by dividing the annual interest rate by the number of days in one year. Suppose your student loan balance is $5,000, the annual interest rate is 3.65 percent and there are 30 days in a billing period. The interest factor works out to 0.01 percent or 0.0001 in decimal format. Multiply by 30 days and then by $5,000. The interest charge comes to $15.

In this example, you could pay $15 per month while in school to keep an unsubsidized loan from accruing interest. If you are out of school and making payments, $15 of your loan payment is interest and the remainder goes toward the balance of the loan. As the balance decreases after each payment, less interest is charged.

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