Updated: Nov 20, 2022
Article highlights
- Interest is the cost of borrowing money over time and is generally stated as an annual percentage of the principal amount owed.
- Fixed interest rates remain the same throughout the life of the loan while variable rates may change periodically.
- Interest accrues daily while you are in school and during your grace period. This amount increases your total loan balance during repayment.
You've been through the tests, applications, and nail-biting anticipation of getting into college or graduate school. And you may have spent a lot of time researching your options to figure out which school is the best fit. Fortunately, there's no big test for your next important decision—choosing your student loan and lender.
Learning how student loan interest works, how interest rates are determined, and what to expect can help you make an educated decision before accepting a loan offer.
Key terms and concepts
| Principal Balance | The principal balance is the original or unpaid amount of a loan upon which interest is calculated. It may include capitalized interest. |
| Interest | Interest is the amount of money charged to borrow money over time. Interest is generally stated as an annual percentage of the principal amount owed. The loan's interest rate determines how much interest accrues on your principal balance. |
| Accrued Interest | The amount of interest that accumulates on the unpaid principal balance of a loan. Typically, it is calculated daily. |
| Annual Percentage Rate (APR) | A percentage which represents the annualized cost of credit for a loan including finance charges (interest, fees, and other charges). The APR may be higher or lower than the interest rate. |
| Capitalization | The process of adding the unpaid, accrued interest to the principal balance of a student loan when the borrower postpones paying interest during a deferment or forbearance. This will increase the principal balance due on your loan, the amount of your monthly payment, and the total cost of your loan. |
| Grace Period | A period of time when the borrower is not required to make student loan payments. It’s usually six or nine months after the borrower ceases to be enrolled in school at least half-time. |
Fixed vs. variable interest rates
When you apply for a private student loan, you may have the choice of selecting either a fixed or variable interest rate.
A fixed interest rate will remain the same throughout the life of the loan. It gives you the security of knowing how much you will pay each month, but could mean you pay more over the life of your loan because fixed interest rates generally start higher than variable interest rates depending on the economy. If you want predictable monthly payments and stability, a fixed interest rate may be the best option for you.
In contrast, a variable rate is an interest rate that may change periodically throughout the life of the loan. Variable interest rates are tied to an index. If the index changes, your loan’s interest rate will fluctuate with it.
The interest rate chart is for illustrative purposes only and does not reflect specific past or future performance.
Increases in the interest rate on a variable rate loan could impact your budget. If your interest rate increases, your monthly payments will increase, and that can be challenging to manage when you are balancing your monthly budget. However, if you know you will pay off your loan quickly, then a choosing a variable rate loan with a lower starting rate than a fixed loan may be a good option.
If you choose a variable interest rate loan, your rate will not be exactly the same as the rate index.
That’s because variable rates are made up of two components: the index rate plus a margin. The margin is an additional rate or range of rates that lenders add based on several lending criteria.
Changes in interest rate indexes can be hard to predict since all sorts of complex factors like the economy and inflation influence them. Since variable interest rate increases and decreases are unpredictable, your monthly payment may increase and decrease during the life of your loan.
How are interest rates determined?
Whether you're looking for a fixed or variable rate student loan, your interest rate will be determined after you apply. How the interest rate is calculated can depend on several factors.
Federal student loans have fixed interest rates. Federal law sets the rates, which vary depending on the type of loan and when you first receive your disbursement, but not your creditworthiness.
For private student loans, rates can vary depending on the lender and your creditworthiness, which may include your credit score, credit history, income, and other outstanding debt. These factors play a significant role in determining your eligibility for a loan and the rate you receive.
Having a creditworthy cosigner, especially if you don’t have an established credit history, may improve your likelihood for loan approval and may lower your interest rate. Even if you qualify on your own, you may receive a lower interest rate by adding a cosigner.
How does student loan interest work?
Most lenders allow you to postpone making payments while enrolled in school at least half-time and during your grace period. While you are in school and during your grace period, interest accrues daily. When it’s time to start making payments, the accrued interest is added to your principal balance—or capitalized. Your interest rate will apply to this new, larger principal balance. This will increase the amount of your monthly payment, total loan balance, and the amount of interest you pay back.
If you choose an in-school repayment option, you can reduce the amount of interest by making payments while in school and during your grace period. Regardless of which repayment option you choose, you can always make payments at any time with no prepayment penalty.
Choosing a loan that's right for you
With an understanding of key terms and concepts, and how student loan interest works, you can start evaluating private student loans and comparing lenders. To decide which lenders are a good fit, look at the loan options, APR ranges, fees, and additional benefits.
The APR may be higher or lower than the interest rate offered.
When comparing private student loan options, look at the APR. It reflects the annualized cost of credit and includes finance charges such as interest, fees, and other charges, and considers whether payments are deferred during school. Because it includes these variables, comparing APRs from different lenders can help you determine which option is potentially the cheapest.
