Unless you have a rich uncle lending you free money for college, you will have to pay interest on whatever federal and private student loans you take out for your education. Interest makes your college education cost more than the original amount you borrowed. If you don't know how student loan interest works, this article will tell you everything you need to know.

How is Student Loan Interest Calculated?

Federal and private student loan interest rates are each calculated differently. They are both based on the Prime Rate set by the Federal Reserve, but they are determined by the federal government and private institutions, respectively.

Federal Student Loans

All federal loans have a fixed interest rate, meaning the rate will remain the same during the life of the loan. The interest rate resets every July 1 for the upcoming academic year. The base rate is determined by the yield on the 10-year Treasury bonds in May. The Department of Education then adds a marginal percent to offset administrative costs such as subsidized interest and other needs-based financial aid.

Undergraduate Stafford loans, for example, have a fixed interest rate of 4.45 percent for the 2017-18 academic year. This interest rate is calculated by the 2.40 percent May auction bond yield plus 2.05 percent margin. Direct PLUS loans (for graduates and parents) will have an interest rate of 7 percent (2.40 percent bond yield plus 4.60 percent margin).

Private Student Loans

Private loans are based on the Prime Index or London Interbank Offer Rate Index (LIBOR) plus a margin that varies with each lender. For variable rate loans, where the interest rate can fluctuate for the life of the loan, many lenders prefer the LIBOR 3-month rate.

With private loans, you can choose a fixed rate loan that will remain the same for the entire repayment term (i.e. 6.8 percent for ten years). Or, for example, you can choose a variable rate loan that can start with an interest rate of 4.49 percent for the first three months, and go higher or lower to mimic the 3-month LIBOR rate.

Unlike federal student loans where every applicant receives the same interest rate, the lender margin rate is also based on your credit score. If you or your cosigner has good credit and a favorable application, then your interest rate will typically be lower than an applicant with undesirable credit.

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How is Student Loan Interest Compounded? How Often Does it Accrue?

There are two different ways your student loan interest can compound depending on how long you wait to enter repayment status.

The first way involves deferring your interest payments while you are still a student. Throughout this period up to the end of the six-month grace period, interest accrues each day. Six months after you graduate or become less than a full-time student, your student loans enter repayment status. Before this six month mark, you have the option to make a lump sum payment to repay all the deferred interest that has accrued as a student. Whatever interest you do not pay before your loans change to repayment status will capitalize. When your interest capitalizes, it is rolled into the principal. This is a lump sum capitalization that is unique to the deferment process and grace period on student loans, but it isn’t the standard for interest accrual.

The other way is the golden standard for interest capitalization, or compounding interest. Each day, your principal balance accrues interest at a daily rate (the annual rate divided 365 days) and adds onto the principal balance. The next day, the daily rate accrues on a new principal balance that accounts for the interest from the previous day on top of the old principal amount.

All student loan interest accrues every day. Even for loans with a deferment or grace period, interest accrues daily after that initial capitalization.

Summary

Student loan interest rates are fairly easy to understand. Each lender uses slightly different criteria to calculate the original interest rate. For fixed rate loans, you do not have to worry about the rate rising. No matter if you have a federal or private student loans, interest accrues daily and you are responsible for paying it first before you can reduce the borrowed principal.