Lesson 4.2 · 3 minHow loan interest adds upHow loan interest adds up
Here you learn how a loan grows from the day the money arrives, so you can estimate what you will owe later. Once you see where the interest comes from, you can decide whether to chip away at it while you are still in school.
Principal, rate and the daily count
The principal is the amount you borrowed. The interest rate is the yearly cost of borrowing it, and on federal loans that cost is worked out a little each day on the principal you still owe. When your balance goes down, the daily interest goes down with it.
Federal loans also charge a loan fee, which is taken out of each disbursement before the money reaches your school. You owe the full amount you borrowed, even though a slightly smaller amount was paid out. The fee for each loan type is listed each year on studentaid.gov.
When interest starts
On subsidized federal loans, the government pays the interest while you are in school at least half-time, a feature the next lesson covers in detail. On other student loans, interest starts building the day the money is paid out. It keeps building through every term, every summer and the months after you leave school.
While you are enrolled, payments are usually on hold, which makes it easy to forget the interest is there. Your loan servicer can show you the interest built up so far, and you can see federal balances on studentaid.gov as well.
What capitalization does
Capitalization means unpaid interest is added to your principal. From then on, interest is charged on the larger balance, so you end up paying interest on interest. For federal loans it can happen at set points, such as when repayment begins after the grace period.
Private lenders write their own rules on when interest is added to the balance. Some add it every few months and some add it once when school ends, so look for the word capitalization in the loan agreement.
Paying a little while you study
Federal loans let you pay early or pay extra at any time without a penalty. Sending even small amounts toward the interest while you are in school keeps it from joining your principal later. Ask your servicer how to make sure an extra payment goes to the loan you choose.
A student with a summer job, for example, might set aside part of each paycheck for the interest on an unsubsidized loan. The balance on the day repayment starts is then much closer to the amount first borrowed.
Try this week
- Find the interest rate and fee for each loan you hold
- Look up how much interest has built up so far
- Ask your servicer how to make an interest-only payment
- Note the date each loan's interest began
Takeaway. Interest you pay while still in school never joins your principal, so even small payments now shrink what you owe later.