The type of student loan you get makes a difference in how much you must pay back.

If you follow the headlines you know that student loans debt is crushing a lot of borrowers. The cost of an education is something many people must finance, but how they finance it can mean the difference between successful repayment and struggling with debt. To understand why, let’s look at simple interest vs. compound interest.

Most student loans charge simple interest. This means the borrower only pays interest on the principal. Federal student loans and many private loans use simple interest. However, some private lenders charge compound interest where interest is paid on both the principal balance and unpaid interest—this is how student loan debt can snowball.

The difference between simple and compound interest student loans

Loans where interest is applied only to the principal are called simple interest loans. With a fixed-rate simple interest loan, part of each monthly payment is applied to the principal balance and part covers the interest.

Things get more complicated—and costly—with a compound interest loan. Student loans typically accrue interest daily and compound daily or monthly. In practical terms, this means the borrower pays interest on the interest.

How simple interest is calculated

Calculating simple interest is straightforward: Multiply the principal by the annual interest rate and that’s how much interest is charged in dollars. For example, a $10,000 loan at 5% is figured like this:

$10,000 x 0.05 = $500

$500 is the annual interest expense on this loan. In a few years, when the balance the is down to $7,500, the annual interest will $375.

Using our online loan calculator, we see that the total interest paid on a simple interest $10,000 loan is $2,727.70 after it’s paid back in 10 years.

How compound interest is calculated

Calculating compound interest is more involved. A student loan with daily compounding accrues interest every day, and the interest is added to the balance. Every day the balance goes up.

To calculate daily interest, divide the annual interest rate by 365. Here’s how a 5% rate breaks down to a daily rate:

0.05/365 = 0.00013699

On the first day of a $10,000 compound interest loan, the interest is $1.37 (rounded up); here’s the math:

$10,000 x 0.00013699 = $1.3699

On day 2, the loan balance is $10,001.37. Multiple this by the daily interest rate and then add it to the balance:

$10,001.37 x 0.00013699 = $1.3700 daily interest accrued

                         $1.37 + $10,001.37 = $10,002.74 new balance

On day 3, another $1.37 interest is added to the balance:

                         $10,002.74 x 0.00013699 = $1.3702

Day 4 starts with a loan balance of $10,004.11.

While these daily charges might not seem that big at first, by the end of one month, $10,000 becomes a $10,041.18 debt, including the accrued interest. In a year, it grows to $10,514.12. As the balance grows, so does the interest fee.

Over the life of the loan, a compound interest loan will cost student loan borrowers significantly more.

When does interest start accruing?

As soon as a lender issues the money for a student loan, interest starts accruing. Even if you’re not yet required to make payments, interest is charged.

Federally subsidized loans typically pay accrued interest while you’re in school and if the loan is in deferment.

Borrowers with private loans sometimes make interest-only payments while they’re still in school to help keep loan balances down.

Tips for student loan borrowers

If you’re seeking a student loan—or already have one—keep these tips in mind:

• Read the fine print BEFORE signing on a student loan. Understand how the interest works and when repayment will start.
• If you already have a compound interest loan, consider refinancing it with simple interest loan.
• If you make extra payments, give your loan servicer directions to apply it to the principal. Without specifying this, some servicers will apply the extra funds to the next payment, which won’t help you pay the loan down faster.
• If you make extra payments for principal, check your statements every month. Many borrowers complain to the Consumer Financial Protection Bureau that servicers don’t always apply payments as intended.
• Check out our blog on restarting student loan payments that includes tips on adjusting your budget when it’s time to repay your loans.

Plus, as a Consumers member, remember that you can get free one-on-one budgeting help through GreenPath Financial Management.

 

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