How Does Student Loan Interest Work?
BIG Ideas:
- Interest is essentially the cost of borrowing money.
- With fixed-rate interest, your rate or payment won’t change, while variable-rate loans could be subject to rate changes, which may affect your payment amount.
- Shortening the term of your loan, paying interest while in school, or refinancing your loans could help you lower the amount of total interest you pay on your student loans.
There are some things in life you can count on. The sun will always rise in the east and set in the west and you’re sure to get buried with tests, assignments, or other work right before a school break. And, of course, if you need to borrow money to pay for college, you’ll have to pay it back – usually with interest.
The rate and type of interest charged on student loans, or any other loan for that matter, can have a significant impact on how much you’ll owe and your monthly payment. That’s why you must understand how interest works before you apply for a loan. To help you prepare, we’ve put together this quick primer:
What is an Interest Rate?
An interest rate is the percentage a lender charges for borrowing money. It represents the cost of taking out a loan, whether it’s for a student loan, car loan, or mortgage. There are two types of interest rates:
- Fixed-interest rate. With a fixed-rate loan, the interest rate will stay the same for the entire life of your loan. The benefit of a fixed interest rate is that it makes it easier to budget since your monthly payments won’t change.
- Variable-interest rate. In contrast, with a variable-rate loan, the rate and your monthly payments are subject to change. Variable rates are based on a financial benchmark or index. So, whether your rate (and payment) goes up or down will depend on what’s happening with the index rate. However, many lenders will set caps on how much a variable rate loan can increase.
In general, federal student loans (loans from the government) offer fixed interest rates, which are determined by federal law. Private student loans (loans from banks, credit unions, and other non-government lenders), however, may offer fixed or variable rates. Plus, unlike with federal loans, interest for private loans can vary significantly by lender, so make sure you shop around and compare rates.
However, when shopping for lenders, keep in mind that the interest rate alone doesn’t account for additional fees or charges, such as application or origination fees. That’s where annual percentage rate, or APR, comes in.
What is an APR?
Unlike an interest rate, the annual percentage rate (APR) includes both the interest and any additional costs that come with securing a loan, such as application or origination fees. This provides a clearer picture of the total borrowing cost and makes it easier to compare loan options side by side.
What is Interest Capitalization?
Another important thing to understand about student loan interest is referred to as capitalization. It’s interest that’s charged on any interest you haven’t paid. For example, if you decide to wait until six months after you graduate to repay your loans (something known as deferment), interest on your loans still accrues while you’re in school. That unpaid interest is then added to your principal balance, making your monthly payments higher when you pay back your loan.
If, however, you have a federal subsidized loan, the government pays your interest while you’re in school, so your principal will not increase.
When interest is capitalized, the overall cost of the loan increases Lenders may have different actions that trigger interest capitalization and it is important to understand when the loan products you are looking at capitalize interest so you can better manage and understand the potential overall cost of your loan.
What Should You Consider When Applying for Student Loans?
As you begin shopping for student loans, consider the following, which will impact not only your monthly payments but also the amount you’ll pay back in total:
- The type of loan you have (federal vs. private). Private student loan interest is often higher than federal loan interest.
- The repayment term you choose. For example, will you make interest-only payments or full payments of principal and interest in school or defer paying until after graduation?
- The type of interest. Variable rates can be lower, but they could increase depending on market conditions. When you compare lenders and rates, make sure you understand the type of interest rate they offer.
- The term of your loan. In general, the longer you take to repay a loan, the more interest you’ll pay in total. With many loans, you can pay more than the minimum payment, which will go directly on the principal, helping reduce interest fees.
- Your credit score. If you need a private loan, the rate will depend on your credit. If you have good credit, you’ll get a lower rate that can save you money. If you don’t have established credit, consider getting a co-signer with good credit to help you get the best interest rate for private student loans possible.
Refinancing Your Loans Could Help You Lower Interest Fees
If you have higher-rate loans, you could refinance your student loans to get a better interest rate. Just be aware that even with a better interest rate, if you refinance for a longer term, you may pay more interest over time. Keep in mind, also, that refinancing federal loans to a private loan could result in the loss of some federal loan benefits, such as income-driven repayment and loan forgiveness.
Brazos is Interested in Making College Affordable For You
For more than 40 years, Brazos Higher Education has been helping make education more affordable for students. As a Texas non-profit, we offer great rates and no fees on private student loans. Contact us to learn more.
