Almost all student loans use simple interest.
Simple interest loans charge interest only on the principal. Compound interest loans charge interest on the principal and any unpaid interest, which makes them more expensive than simple interest loans.
All federal student loans use simple interest. If you’re considering a student loan, understanding how the interest works can help you save money overall.
How interest is calculated
Simple interest is a method of calculating interest charges based on the principal balance only. Monthly simple interest is calculated by multiplying three factors: the daily interest rate, the principal (loan balance) and the number of days between payments.
The simple interest formula charges interest only on the principal, so the daily interest cost stays the same throughout the payment period. If your interest cost is $3 a day and you have a monthly billing cycle, your total interest for the month is $90.
With compound interest loans, you’re always paying interest on your interest. That is, the daily interest rate is applied to the principal plus any unpaid interest up to that moment. If your loan compounds interest daily, each day unpaid interest is added to your principal balance.
For example, your loan balance is $30,000 and your initial daily interest amount is $3. The next day, that interest is added to the principal, so you’re charged interest on $30,003. The increase in principal also increases your daily interest charge. The interest charges will increase as such each day until your next payment.
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Even federal student loans can compound interest
Even for simple interest student loans, compounding can still be a factor.
There are times such as forbearance or consolidation when unpaid loan interest capitalizes, or is added to your principal balance. Capitalization increases your principal amount, which increases your daily interest amount and the overall cost of your loan.
You can avoid capitalization by paying at least the interest owed on your loans each month when your loans are not yet in repayment or if you are on an income-based repayment plan.
Key Terms in This Story
Capitalization: A process that adds unpaid interest to the principal balance of your loan, increasing the amount on which you pay interest going forward. Capitalization generally happens after periods of authorized nonpayment, like deferment and the grace period. You can avoid capitalization by paying at least the interest on your loan each month.
Interest: The cost of borrowing money for school, not including any fees. Most student loans calculate interest using the simple daily interest formula.
Simple interest: A method of calculating interest charges that is based on the principal balance only. Loans that use the simple daily interest formula are cheaper than loans that use a compounding formula, because they don’t charge interest on interest.