When you take out a student loan, interest begins to accrue, or build up, on your outstanding balance. This is usually calculated daily. For example, a $20,000 loan with a 6% annual interest rate accrues about $3.29 in interest each day. While this seems small, it adds up over the life of the loan, which is why early payments often go more toward interest than the principal balance.
Fixed vs. Variable Interest Rates
Student loan interest rates come in two main types, and the one you have significantly impacts your repayment plan.
- Fixed Interest Rate: A fixed rate is locked in for the entire loan term. If your rate is 6%, it will always be 6%. This provides predictable monthly payments, making it easier to budget. According to the U.S. Department of Education, all federal student loans issued since July 1, 2006, have fixed interest rates.
- Variable Interest Rate: A variable rate can change over time because it is tied to a market index, such as the SOFR (Secured Overnight Financing Rate). These rates may start lower than fixed rates, but they carry the risk that your payments could increase if the index rises.
How Rates Are Determined: Federal vs. Private Loans
The origin of your loan is the biggest factor in how your interest rate is set.
- Federal Student Loans: Congress sets the interest rates for federal student loans annually. The rate depends on the loan type (e.g., Direct Unsubsidized for undergraduates, Direct PLUS for graduate students or parents) and the year the loan is disbursed. Crucially, federal rates are not based on your credit score.
- Private Student Loans: Private lenders, such as banks and credit unions, set their own rates based on the borrower’s (or cosigner’s) creditworthiness. They evaluate factors like credit score, income, and other debts to determine your rate. A stronger financial profile typically results in a lower interest rate.
What Is Interest Capitalization?
Interest capitalization occurs when unpaid accrued interest is added to your loan’s principal balance. After capitalization, you begin paying interest on the new, larger balance. This can cause your loan balance to grow, especially after periods when payments are not required.
Capitalization commonly happens at the end of a grace period, deferment, or forbearance. You can prevent capitalization by making interest-only payments during these periods if your loan servicer allows it.
How to Lower Your Student Loan Interest Costs
- Enroll in Autopay: Most federal and private lenders offer a 0.25% interest rate reduction for enrolling in automatic payments.
- Improve Your Credit Score: Before seeking a private student loan or refinancing, improving your credit can help you qualify for a more competitive rate.
- Consider Refinancing: If you have high-interest loans, you may be able to refinance them into a new loan with a lower interest rate. Refinancing is most common with private lenders and may cause you to lose federal loan benefits, such as income-driven repayment plans. It is different from federal student loan consolidation, which combines loans but does not typically lower your interest rate.
- Claim the Student Loan Interest Deduction: The IRS allows eligible taxpayers to deduct up to $2,500 of student loan interest paid each year. This tax deduction reduces your taxable income, lowering the effective cost of your interest. For more information, see IRS Topic No. 456.