Understanding Student Loan Interest Accrual and Compounding Interest

Interest is a bane for every Student Loan Borrower on the road to Repay off their student loan debts. Payments being made towards interest does not lower the loan balance owed to the lender. Rather, these payments on the interest are how the lenders make money.

It is, therefore, no surprise that most lenders try to increase the portion of payments that count towards interest to the max while trying to lower the number of payments that actually reduce your loan balance.

Table of Contents

Terminology
Payment Process
Interest Calculation
Interest Rates
Prevent Accrual and Compounding
Conclusion

Terminology

Accrued interest: Daily Interest charged on student loans, meaning the loan balance keeps increasing daily.

Interest capitalization: Accrued Interest is added to the principal balance. Normally happens every month.

Compound interest: Repaying Interest on the interest that was added to the principal balance.

Payment Process

Every borrower’s main objective is to reduce their principal balance. Repaying the principal balance in full ends the loan payments. Therefore, the lenders prefer applying your monthly repayments towards your interest rather than your principal balance to extend your repayment duration and earn a higher profit.

The order in which most Lenders apply your payments is:

Fees: Late Fees and any other type of fees, like Origination Fee, etc are paid in full first.
Interest: Unpaid Interests on the Loan are paid next, in full.
Principal: Remaining payments are applied to the principal balance.

One thing to keep in mind though is that some lenders, like Sallie Mae, will take your monthly overpayment amount and apply it to the amount due on your next billing statement. This becomes a big headache for people trying to pay off their student loans as fast as possible.

If your lender is doing the same, then the best thing to do is contact them and instruct them that your monthly overpayments are to be applied to the principal balance rather than future payments.

Interest Calculation

It is relatively simple to calculate the accrual of interest on a student loan and can be done either manually or by using an online interest calculator. For those who want to know more about how it is calculated, simply take the loan balance and multiply it by the interest rate, which gives you the total amount. This amount can then be divided by 365 to figure out the daily interest being generated by the student loan.

Calculating the Interest Rate online is easy and can be done through any one of the several calculators available online.

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Student Loan Interest Rates

Each Student Loan will have varying interest rates. Some loans will have Fixed Interest Rates while others may have Variable Interest Rates. These loan terms will be set up when the loanee signs up for the loan. One of the good news is that there are many ways to get a lowered interest rate on your student loans. Congress sets the rate for Federal Government Loans. Private Lenders use a number of factors such as the Credit Score, Economic Conditions, Lender Cashflow, among other factors. If the interest rate of a loan suddenly goes up, it is because the loan has a variable interest rate. Such Loans are tied up with an index rate such as the LIBOR, a rate used by banks to determine the interest rate during lending services with other banks. The interest rate for such variable rate loans usually changes every 3 months, but can also be affected by the original student loan contract, causing the rate of interest change to become monthly or yearly. An improved credit score might lead to a lower interest rate once the loan has been drafted, though not everyone will be able to get it and not every lender will accommodate such requests.

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Prevent Interest Accrual and Compounding

It is nearly impossible to avoid a loan from accruing interest, the only possible way is to pay off the loan in full. There is an exception for federal subsidized loan borrowers though, wherein they can prevent future interest accrual if they qualify for a student loan deferment. Cancer-Fighting Federal Student Loan borrowers may also be able to get a cease on the interest being charged on their loans. The logic behind preventing Interest Compounding and Capitalization is pretty simple, I.E. as long as a borrower makes monthly payments that exceed the monthly interest and the additional amount going towards principal balance repayment, there will be no interest accruing on top of the monthly interest.

Concluding Thoughts

Hopefully, this article serves as a helping hand in understanding how your Student Loan Lender might try to get a higher profit off your student loan debt by means of Interest Accrual and Compounding and what steps you can take to ensure that you pay as less on interest as possible and are able to clear off your dues as early as possible.