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Interest rates are an unavoidable part of any long-term financing agreement. Whether you're using debt to purchase a home, automobile, or an education, you will invariably need to pay interest on that loan. Federal student loans are no exception, but they do often offer significant advantages over other sorts of borrowing. For instance, everyone receives the same rates, except for those with more financial need, who can receive secured loans. On the other hand, student loans cannot be discharged in bankruptcy and non-payment can result in penalties such as garnishment of your wages or tax refunds. However, you may find that the seeming financial trouble is well worth it.

In fact, student loans often represent a great investment. The product you purchase, a college education, increases in value as your experience increases. Furthermore, your education can never be lost, stolen, or destroyed in any way. Thus, while your education loan might increase in cost due to interest rates, the product itself will continue to gain value as time goes on.

Choose the Right Student Loan That Meets Your Needs

What are Student Loans?

Student loans are financial instruments that are available exclusively to students. Given the rising cost of education, student loans help many, if not most, students pay for their books, tuition, and other expenses. These loans are unique in that they are only available to students and it is impossible to discharge the debt through bankruptcy. Students primarily take out loans through federal providers, but some utilize private student loan lenders if they tap out their access to federal resources or don’t qualify for some of their offerings.

The preferred student loan lender is the federal government, which tends to offer the most favorable interest rates and repayment plans. Federal student loans are not limitless, however, and it is possible to reach the cap amount. Graduate students, who might also have lingering debt from their undergraduate degree, are particularly prone to maxing out their federal loan amount. Students who still need assistance can apply to private lenders such as Sallie Mae, Navient, and Discover Student loans, among many others.

Keep in mind that private student loans are only for expenses stemming from education and that they also cannot be discharged through bankruptcy.

How Do You Apply for Loans?

To qualify for a student loan, you'll need to fill out a Free Application for Federal Student Aid, which you'll soon know as the FAFSA form. This form includes your financial information, as well as that of your co-signer, if you have one. Students must complete the FAFSA every year they are in school, just in case their eligibility has changed. To fill out the application, you'll need the following:

  • Social Security Number
  • Your Parents' Social Security Numbers - for dependent students
  • Your driver's license number
  • Alien Registration Number - if applicable
  • IRS Tax information for yourself and your parents, if you are a dependent, including:
    W-2 information
    Foreign tax return – either IRS 1040NR, or IRS 1040NR-EZ
    Tax returns from Puerto Rico, USVI, American Samoa, or any other US Territory
  • Records of untaxed income such as child support, interest, veteran’s benefits, etc.
  • Accounting for all assets including cash, equities, investment property, etc.

What is Interest?

Interest is essentially a percentage rate that is applied to a principal loan amount. That principal is the core debt. In the case of student loans, the principal covers your tuition. Since banks need to make money, they charge a percentage, called interest, that is added to the repayment amount. Thus, interest is the effective cost of borrowing money and is how banks remain in business and are able to provide more student loans and other services to more people. However, student loan interest works a bit differently than interest on other types of loans.

In the case of mortgages, auto loans, or business loans, interest begins to accrue the moment the loan is written. Secured Federal student loans do not begin to accrue interest until six months after a student graduates or otherwise stops taking classes. After this, interest only stops accruing if the borrower returns to school. Among other things, this means that current students may be able to take advantage of their status and make payments against the principal loan amount before interest begins to pile up, lowering the overall cost of their loan.

Compounded Interest

Compounded interest refers to the interest rate that is applied to both the initial principal amount of a loan plus any interest amount that accrues without being paid. Generally, you pay the interest when you make your payment but, if you underpay or miss a payment, compounded interest means that the interest you didn’t pay now counts as part of your loan, and interest will be charged on the unpaid interest just like it is on the principal. Thus, if you borrow $100 and that loan accrues $10 in unpaid interest, a subsequent interest calculation will include the full $110. In this way, interest compounds on itself over time. If not addressed proactively, borrowers may find that their initial loan amount is dwarfed by compounded interest.

Different loans compound interest at different rates. That is, some will add and compound interest on a daily basis while others may compound interest on a quarterly, bi-annual, or annual basis. Whenever you take a loan, be certain to inspect their policies regarding interest and especially compounded interest.

What Determines Student Loan Interest Rates?

Federal Loans

Student loan interest rates are determined according to a number of factors. There are different rates that apply to your status as a graduate or undergraduate student and whether your loan is subsidized or unsubsidized. Furthermore, interest rates on your student loans are ultimately derived from macroeconomic factors, which are determined by federal legislation.

Undergraduate students can borrow money at a lower interest rate than graduate students. As of this writing, undergraduate students with direct subsidized or unsubsidized loans accrue interest at a rate of 4.53%. Graduate students are only eligible for unsubsidized loans and they borrow at a rate of 6.08%. Some undergraduate students are able to attain subsidized loans, which offer specific advantages. Specifically, only undergraduate students with a demonstrated financial need qualify for subsidized funds. Students from more affluent families or who have significant personal income or assets might not qualify.

Subsidized loans offer a significant benefit for borrowers in that they may accrue interest while students are still working towards their degrees, but the government covers all of the interest amassed during that time as well as any interest that might otherwise accrue during deferment or any other grace periods. Unsubsidized loans may not require payment while the student is studying, but the principal amount will continue to accrue and compound interest. Thus, there are often repayment plans that allow unsubsidized borrowers to make payments on their interest.

Note that interest rates may change over time and they are reassessed annually. However, Federal Student Loan interest rates are standard and apply equally to all borrowers. Those rates are determined by the 10-year Treasury note rate, which is determined in the annual May auction.

Student Loan Interest Rate Payment Calculators

Private Loans

Private student loans are subject to many of the same restrictions as federal loans, but there are significant differences that make them a second choice for many borrowers. One of the chief differences to keep in mind when considering a private student loan is that interest rates are determined on an individual, case-by-case basis. That is, while those with greater financial need may receive subsidized Federal loans, private lenders will charge higher interest rates to those with less credit because they are considered a greater financial risk.

Those with greater financial need are often considered a greater risk, even if they make regular payments on their existing obligations. Unfortunately, this means that they will consistently pay a higher rate of interest for educational and other loans. Furthermore, private lenders may also have stricter rules governing their lending and it may be more difficult to obtain a loan. Borrowers might therefore be more likely to need a co-signer when seeking out a private student loan.

Private lenders may also have different and individual stipulations regarding deferment. Where federal loan payments and interest might be deferred while one's education is underway, or in times of unemployment or financial stress, private lenders will make their own rules. In fact, the rules for borrowers may vary depending on the perceived creditworthiness of each individual. It may safely be assumed that all borrowers will have compounded interest upon graduation, and that the private loans will have higher interest rates.

For instance, during the economic stand-still during the COVID-19 pandemic, the NCUA recommended that its member Credit Unions offer assistance to borrowers. However, those were only recommendations and each individual Credit Union was able to implement its own guidelines for student loan repayments.

History and Future of Federal Student Loan Rates

Over the last ten years, federal student loan rates have fluctuated quite a bit. In 2010, undergraduate loans were written with an interest rate of 4.5% for a subsidized loan and 6.8% for unsubsidized funds. In the years 2019/20 undergraduate students could borrow funds at a rate of 4.45%, whether or not their loans were subsidized. Graduate student loan interest rates haven't fluctuated that dramatically, but they were at 6.8% in 2010/11 and were at 6.08% in 2019/20.

Given that the Federal Reserve lowered interest rates in response to the COVID-19 pandemic and that the economy is at a low point, the May auction is likely to place a rather low rate for Treasury notes. Thus, those who are eager to get back to school will find very favorable federal student loan rates for the remainder of 2020 and at least until May 2021. The economic impact of COVID-19 has been so dramatic that it's likely to ripple through financial markets for a year or more. In fact, some speculate that undergraduate lending rates could go as low as 3.29% and graduate loans could fall to 4.84%.

The pandemic's effect should keep student loan interest rates lower and thus incentivize students to seek more academic training. Once those students begin to enter the workplace with historically low debt loads and greater skills, the economy should become even more robust than in previous years. Future students may then face higher rates, but that’s how it works.

How to Calculate Your Student Loan Interest Rate

As you go about planning your budgets or generally accounting for all your expenses, you should calculate your student loan interest and its rate to arrive at a comprehensive financial picture. You should be able to find your interest rate in your loan documentation. Take your annual interest rate and divide that by 365 to arrive at your daily interest rate.

Once you have your daily interest rate, multiply that by the outstanding principal amount from your loan statement. You can convert that into a monthly interest rate by multiplying the daily rate by the number of days in a statement cycle. That figure is then multiplied by 12, thus yielding the amount of interest you pay each year. Here is the formula in a more mathematical expression:

[((Annual Interest Rate / 365) * Outstanding Principal & interest) * Days in a Statement Cycle] * 12

How Your Payments are Applied to Your Loan

When you make the minimum payment on a loan, it's likely that you are primarily paying off accrued and compounded interest. This means that your monthly minimum may not cover as much of the principal loan amount as you think. However, if you increase your payments, you can really begin to make a dent in the principal loan amount.

Unlike some other sorts of loans, such as mortgages, you can increase your student loan payments when you are able. For instance, if you received a bonus at work, you might put some of that towards a student loan payment thereby reducing your principal and overall debt over time.

What the Interest Rate Looks Like in Action

  • Associate Degrees:
    These degrees are typically a lower-cost, entry-level education intended to launch a career. If you attend a community college, you'll pay less per credit hour. The average cost of an associate degree from a public, in-district community college is about $4,864 per year. A two-year degree thus costs around $9,728 before other expenses including books, fees, and room and board. When you apply the 2019-20 undergraduate interest rate, 4.45%, graduates will pay a daily rate of 0.000123, or $1.20 in interest each day. During a 30-day payment cycle, graduates will pay approximately $36 worth of interest. Any amount paid over that should apply to the principal loan amount.
  • Bachelor’s Degrees:
    On average, a four-year bachelor’s degree from one's in-state, public university will cost a total of $33,450. Assuming that a student has a secured loan, their interest will accrue by $4.11 per day, or $123.30 per 30-day payment cycle. Since there are other costs associated with a four-year degree, the total cost of your education is likely to be larger.
  • Master’s Degrees:
    Graduate students are charged a higher interest rate for their education. This is largely due to the assumption that a graduate degree results in more opportunities and higher pay. The average cost of a graduate degree is approximately $29,960 and students entering graduate school for the 2019/20 school year are signing loans at a rate of 6.08%, which translates to ~0.00016% per day. Each payment cycle will thus include approximately $143.80 in interest, assuming that the debt was not increased to cover non-tuition expenses.

How to Reduce the Amount of Interest You Pay

To avoid paying any more compounded interest than you need to, consider taking proactive measures. That is, if you have an unsubsidized loan you should try to make interest payments while still in school. Those with subsidized loans might also make payments against the principal loan amount and thus avoid long-term interest woes. Yet another tactic would be to reduce the loan amount by securing degree specific grants or scholarships that needn't be repaid.

Students can also reduce paying excess interest by opting for a shorter-term repayment plan. Your monthly payments will be necessarily higher, but you'll do more to reduce your principal loan amount each month than if you opted for a long-term payment plan.

Another option is to refinance the student loan at a lower rate. Since May 2020 is bound to see a marked reduction in student loan interest rates, student-loan lenders might take advantage and find long-term relief from their loan payments.

You might also seek to avoid any period of loan forbearance, during which time your debt load will continue to accrue interest. If times are tight and your finances are strained, consult with a loan service professional and try to arrange for comfortable, low payments that will slow the acceleration of compounded interest.