Are Student Loans Compound or Simple Interest?

Student loans can be complicated, especially when it comes to interest. Compound interest tends to be more expensive than simple interest, so you may be relieved to learn that most student loans use a simple interest formula. 

Interest charges can still be significant, but you generally won't have to pay interest on top of interest. Understanding how interest adds up on your student debt can help you better manage it and control your long-term cost of borrowing. 

Current student loan refinance rates

Do student loans use compound or simple interest?

All federal student loans and most private student loans use a simple daily interest formula when calculating your interest charges. With simple daily interest, you only pay interest on the amount you borrowed.

By contrast, a compound interest formula continually adds interest charges to your principal balance. Then, you end up paying interest on top of a new, higher balance.

“In nearly all scenarios, simple daily interest allows the borrower to pay less in interest over the life of the loan, as compared to compound interest,” says Sarah Austin, a policy analyst at the National Association of Student Financial Aid Administrators (NASFAA).

While compound interest student loans are rare, there are a few circumstances where you'll pay interest on top of interest. This happens when interest capitalizes, or is added onto your principal balance.

Interest may capitalize at the end of a student loan deferment or if you leave the Income-Based Repayment (IBR) plan for federal student loans. Interest capitalization can seem like compound interest and cause your borrowing costs to increase.

How does interest accrue on student loans?

Interest accrues on student loans on a daily basis. It's calculated as a percentage of your principal, which is the amount you originally borrowed.

If you know your student loan interest rate, you can calculate your daily and monthly charges with the following formula:

Interest amount = (Outstanding principal balance x interest rate factor) x number of days since last payment

Your interest rate factor is your interest rate divided by 365.25 (the average number of days in a year, accounting for leap years). Let's say, for example, that you owe $40,000 at a 6% rate. Here's what the calculation would look like:

Interest rate factor = 0.06 / 365.25 = 0.000164

Interest rate factor multiplied by principal: 0.000164 x $40,000 = $6.56

In this case, your student loan is accruing $6.56 per day. If it's been 30 days since your last payment, you would multiply that number by 30 to figure out how much you pay in interest per month ($196.80). As you pay down your principal, your interest charges will decrease, as well.

You don't have to do the math manually, though — a student loan repayment calculator can crunch the numbers for you.

Most student loans accrue interest from the date of disbursement, as well as during periods of deferment and forbearance. The only exception is federal subsidized loans, as the government covers interest charges while you're in school, during your grace period, and during any approved deferment periods.

What is capitalized interest and why does it matter?

There are a few circumstances when interest can capitalize, or be added onto your principal student loan balance. If you have Direct Loans or Federal Family Education Loan (FFEL) program loans managed by the Department of Education, interest can capitalize in these situations:

• After a period of deferment ends (unsubsidized loans only; for subsidized loans, the government covers interest charges during this time)
• If you leave the Income-Based Repayment plan voluntarily or because you no longer qualify

If you hold any FFEL program loans not managed by the Department of Education, interest can also capitalize after a forbearance or at the end of your grace period if you have unsubsidized loans.

Interest capitalization makes your principal balance go up, which in turn increases your interest charges. You might also see your monthly payments go up, depending on your repayment plan.

According to Cathy Lu Espel, a certified financial planner (CFP) at First Horizon Advisors, understanding capitalization is crucial for borrowers to prevent a significant increase in monthly payments.

“Making interest payments during deferment or forbearance can prevent that and keep your balance from growing unexpectedly,” she explains.

What's the difference between subsidized and unsubsidized student loans?

The way interest accrues on your loans will differ depending on whether you hold subsidized or unsubsidized loans. Subsidized loans are the more affordable option because they come with an interest subsidy.

The government covers the interest charges on subsidized loans while you're enrolled in school at least half-time, during your grace period, and during any deferments. If you leave school or graduate, the clock starts ticking — you'll have six months before your grace period ends and interest starts accruing.

“These loans make it easier to focus on school without the pressure of immediate repayment,” says Espel.

Unsubsidized loans also have a six-month grace period, but they don't have an interest benefit. Unsubsidized loan interest accrual starts from the date of disbursement. Plus, unsubsidized loans accrue interest during periods of deferment, so your balance will grow while your payments are paused.

Subsidized loans are only available to undergraduate students with financial need, and they have lower borrowing limits than their unsubsidized counterparts. Unsubsidized loans are available to both undergraduate and graduate students, and don't have a financial need requirement.

How can you reduce the interest you pay on student loans?

Keeping up with interest can be one of the hardest parts of paying off student loans. Here are a few strategies for reducing your interest charges:

• Pay off the interest while in school: Most student loans let you postpone payments while you’re in school and for 6 months after you graduate. But opting to pay off the interest during this time can lower your borrowing costs. This is especially true for private student loans, where interest may capitalize when your grace period ends. 
• Avoid deferment and forbearance if you can: Deferment and forbearance can offer relief if you run into financial hardship, but your federal unsubsidized loans and private student loans will accrue interest during this time. Try to avoid deferment and forbearance unless absolutely necessary. If you have to use these options, consider paying off the interest charges during them. 
• Pay more than the minimum: If you can increase your monthly payments — or make extra payments once in a while — you could reduce your interest charges and pay off your loans faster. Consider directing extra payments toward your highest-interest loan to save the most on interest. This strategy is known as the debt avalanche. 
• Prevent capitalized interest: Find out when interest could capitalize on your student loans so you can stop it from happening. For example, make sure to recertify your Income-Based Repayment plan annually (or allow the Department of Education to do it automatically) so you don’t get kicked off the plan. If you’re leaving IBR or a period of deferment, consider paying down your interest charges before they can capitalize on your principal balance. 
• Explore refinancing for a better rate: Refinancing student loans can result in a lower interest rate, especially if you have strong credit. A lower interest rate can lead to significant savings over time. Keep in mind, though, that refinancing federal student loans means forfeiting access to federal repayment plans, forgiveness programs, and other benefits.