Student Loan Interest Explained – How It Accrues, Capitalizes and Drives Up Your Debt

March 18, 2014

If you know anything about loans it’s that they come with interest, but do you know how interest works? Do you know when it starts accruing and how often it does? Most people don’t, so there’s no shame in your game unless you’re a finance, econ or accounting major (this group should totally be in the know). Today we’ll take a look at how interest builds up and how interest can pile onto interest and make your loans much higher than what you started out borrowing.

How interest rates work

Student loan interest explained

How interest accrues while in school

Only subsidized federal student loans do not accrue interest while you’re in school and only those whose families are most financially challenged have access to those loans. For today’s discussion, we’ll work under the assumption that you have unsubsidized loans. This means that from the moment you sign on the dotted line and your loan is disbursed, your loans will begin racking up interest. And if you don’t pay this interest while you’re in school, it will add on to the principal of your loan. This process is called capitalization and essentially means that from that point, you’ll be paying interest on the total of what you borrowed plus the interest that’s built up while you’re in school. Check out the math:

Freshman year: You borrow $5,500 at 3.86%. By the time you graduate in four years, this will have grown to $6,401 – an $836 increase.

Sophomore year: You borrow $6,500 at 3.86%. By the time you graduate in three years, this will have grown to $7,284 – a $741 increase.

Junior year: You borrow $7,500 at 3.86%. By the time you graduate in two years, this will have grown to $8,091 – a $570 increase.

Senior year: You borrow $7,500 at 3.86%. By the time you graduate in one year, this will have grown to $7,790 – an increase of $285.

How the accrued interest impacts your student loan payments

If you choose not to pay your interest while in school, in this scenario, you’ll owe $2,432 more when you come out. You would likely be expecting a bill of $27,000 upon graduation (the face value of your loans), but instead will be facing $29,432. Here’s how this will impact your monthly payments – on a 10 year loan, the $27k face value will cost you $272 a month. But with the capitalized interest tacked on, you would pay $296 a month. That may not seem like a lot, but the interest adds up. You’ll pay $6,092 instead of $5,588. The more you borrow, the longer you’re in school and the higher your interest rates are, the more profound the impact will be.

Smart money is on avoiding capitalization while in school. For this scenario, paying just $17/month in year one, $38 in year two, $62 in year three and $86 in year four will keep this interest from building up and raising your loan balance. Paying this amount, at a minimum, will make life easier for you financially when you graduate. If you can, though, you should pay even more in and take a cut out of your principal as well.

Interest diminishes over life of the loan

Student loan interest
Image source: StudentAid.ed.gov

How interest accrues over the life of your loans

Each month, interest accrues on your unpaid principal balance. If you are making your assigned payments according to a standard 10 year repayment plan, your payment will cover the amount of interest that accrues each month and some on your principal. As your loan progresses, more of your payment will apply to principal and less on interest, but in the early years it will be more interest that you’re paying in. If you pay less than your monthly required payment, you will see unpaid interest carry over into your balance and generate even more interest in future months.

How IBR increases what you pay over time

IBR vs 10 year repayment plan
Image source: FinAid.org

If you opt for Pay As You Earn or Income Based Repayment and your payments are not high enough to cover the interest that’s accruing, your loan balance will grow rather than diminish. If you stick with IBR or PAYE all the way up until the balance is forgiven, the balance may have grown significantly. See the table above. If you are earning $25,000 a year, your IBR payments would hover around $100 unless you had a significant uptick in income. All of your payment would go to interest, but interest would continue to accrue. This would see you paying more than $26k in interest rather than $6k under a 10 year plan, and you’d be left with a $28k balance that would be forgiven – more than you initially borrowed. Depending on your tax rate, you would owe several thousand in taxes. In his latest budget proposal, President Obama has suggested that loan forgiveness should be tax free. If this goes through, this would alleviate the main downside to IBR and PAYE.

Be sure to read our blog frequently for lots of tips, info, news and legislative updates. Also, sign up for Tuition.io’s free student loan tool to track your debt and keep an eye on your interest.