Student loans suck. There’s no other way around it. No one likes them and they just seem to suck the money right out of our pockets.
The other day, a good buddy of mine was asking about how to calculate the monthly interest for his student loan. He knew that it was a good idea to start paying the monthly interest now instead of waiting, but he just wasn’t sure how to figure out how much to pay.
After talking to him, it got me thinking. I wonder just how much the average person could save if they paid the interest while in college, instead of waiting until after they graduate.
And I’ll go ahead and spoil it. You don’t have to read the rest of the article to find out.
Here it is:
If you would start paying the interest now, you can save enough money to take yourself on a nice 7-day cruise!
Wouldn’t that be sweet? Unfortunately, most college students don’t think about starting to pay their loans early, much less what they could do with the money they save.
But if you’re interested in seeing how this works and how to get that cruise, just keep on reading and I’ll lay it all out for you.
Different Types of Student Loans
Before you grab your swim trunks and flippy floppies you’ve got to understand the different types of loans you may have. Basically, there are two broad categories of student loans: federal loans and private loans. These loans are treated differently, so it’s important to know what you’ve got (and you may have some of both).
Federal student loans come from, you guessed it, the government. They have names like Direct Subsidized Loans, Direct Unsubsidized Loans, Direct PLUS Loans, and Federal Perkins Loans. These are different from private student loans that come from banks, credit unions, schools, and other non-government lenders.
The nice thing about federal loans is that the interest rate is mandated by law and cannot be above a certain amount. Unfortunately, with private loans, there is no limit on the interest rate so it can vary depending on the specific lender, the amount you borrow, and your credit worthiness.
The first step to figuring out how interest works on your student loans is to determine what type you have and then looking at the terms of each loan to learn what interest rate it charges.
When Interest Starts Accruing On Your Loan
After you figure out your type of loan and the interest rate, you need to check the specific terms of your loan to find out when interest starts accruing. This just means, when is interest going to start building on your loan.
For Federal Unsubsidized Loans and Private Loans, your interest starts accruing the second that loan gets sent to you.
That doesn’t necessarily mean that you must start paying money yet, it just means that the interest is starting to build.
So if you get a Direct Unsubsidized Loan during your first semester freshman year for $5,500 on August 15th, interest will start building on that money immediately. And it will continue to build for the next 4 years until you graduate and start paying it back. It builds even if you aren’t forced to start paying yet.
If you have a Subsidized Loan, it won’t start building interest until 6 months after you graduate. This is absolutely huge and a major advantage if you qualify for these loans.
But unfortunately, the majority of people don’t qualify for subsidized loans, so you probably should keep reading to find out what to do about all that interest.
Understanding Interest (Simple vs. Compound)
Learning when your interest starts building is only half the battle, now you gotta understand how that interest builds.
Luckily, student loans start gaining interest with what is called Simple Interest. This type of interest is only based on the principal loan amount.
Let’s take a look at an example. Yes that means doing math, but don’t worry, we’ll take it easy. You’ll be lounging on the top deck soon enough.
Let’s say you have a $5,000 loan with a 5% annual interest rate. To find out how much interest is charged per day here’s the calculation you would use.
So your loan charges you $0.69 per day for borrowing that money. To find out how much interest your loan gains during January, you would just multiply $0.69 by the number of days in January.
If you want to find out how much interest you will be charged for the whole year just use the first equation, except don’t divide by 365.25.
So that’s an example of simple interest. The interest is always calculated based on the original loan amount.
To really understand simple interest, it will help to compare it with compound interest.
So let’s look at the same exact example, except this time we’ll use compound interest.
Alright, so now you have a $5,000 loan with a 5% annual interest rate that compounds daily <– That last phrase is key.
The equation to calculate the interest for the first day is still the same because interest compounds daily (that just means the interest is calculated at the end of each day).
So you’re still charged $0.69 for the first day. But here’s the difference. On the second day, you don’t get charged another $0.69. Instead, you’re now charged on the original loan amount AND the first day’s interest.
So the equation for the second day is
This is why it’s called compound interest. You’re now charged interest on the original amount, plus on the interest that has been growing.
Comparing this to the first example, we can see that instead of paying $250 for the first year, now it’s going to cost $256.34 for the first year. This equation gets a little more complex.
It ended up costing $6.34 more for the first year, just because of the way interest is calculated.
That $6.34 may not seem like a lot at the time. But if you compare simple interest vs. compound interest for 4 years of college, the compound interest ends up costing $106 more in 4 years than the simple interest.
And remember, this is just for your very first $5,000 loan. If you take out more loans during the next few years it’s only going to keep on growing.
That’s why when it comes to student loans, compound interest is not your friend.
Why You Should Pay While Still In College (and how to get that cruise!)
Here’s the thing, most student loans build interest using the simple interest equation described above. That’s super great and it helps save you a lot of money during college.
But here’s the problem, if you don’t pay off that interest before you graduate, most student loans immediately add that to your principal (the original loan amount) and then it starts compounding. This is something known as Capitalization.
So let’s say you don’t pay any interest while you’re in college.
Going back to the example above, this means for that first $5,000 you will be charged $250 every year. So after 4 years you will owe $5,000 for the loan and $1,000 for the interest. But if that interest gets capitalized right after you graduate, now you will start building interest on $6,000 instead of just the original $5,000.
This is going to end up costing you WAY more money in the end.
In order to avoid this, you should try and pay off your interest every month while you’re in college. I know, I know, this probably means getting a job (oh the horror!!)
But seriously, it’s going to be so worth it.
In 2015, the average senior graduated college with $35,000 worth of student loans. That’s scary. And unfortunately, so many people are making it worse by waiting until after graduation to start paying off their loans.
Here’s another quick example based on that average statistic. <— This is where I show you how to get that cruise!
Let’s say you take out a $4,000 student loan every single semester with a 5% interest rate. The interest builds based on simple interest, but it capitalizes after you graduate.
So at the end of 4 years, you will have $32,000 worth of loans. But if you don’t pay any of the interest throughout school, you will now also have $3,600 worth of unpaid interest. This puts your total loan balance up to $35,600.
Using the online calculator at finaid.org, we can figure out how much this costs you in total.
If you pay the $35,600 off in 10 years after graduation, the total amount paid would be $45,311. This means you paid $9,711 in interest.
But what if you were paying off the interest during college so that you only had $32,000 when you graduated. Now if you pay it off in 10 years the total paid is $40,729 with the total interest being $8,729.
That means you save an extra $1,000 in interest just by paying a little extra during college instead of waiting until you graduate.
Just think about what you could do with an extra $1,000 in your pocket…. Oh, I don’t know, maybe take a freaking 7-day cruise.
So that’s it.
Just start paying your interest now, instead of waiting until after college, and look at all the money you save.
Figure Out Your Monthly Payment
Alright, so now you’re convinced that you should probably not wait until you graduate to start paying off your student loans. But how do you know how much you should try and pay during college?
Obviously, the more you can pay now, the less you have to pay later. So for that reason alone you should try and pay as much as you can.
But to help you out I’m going to give you an easy calculation for figuring out how much your interest is every month and then you can start there.
All you need to know is the principal (original loan amount) and the annual percentage rate (APR).
Once you know this, just use this simple formula.
Then do that calculation again with each loan that you have.
Let’s look at one last example.
Let’s say you currently have 3 different loans. The first is $4,000 at 4.5%. The second is $5,000 at 4.3%. And the third loan is $3,700 at 4.7%.
So across all three loans, the total amount of interest charged is $47.92
If you want to be safe, just pay $48 every single month and you’ll be good to go!
Like I said earlier, the more you can pay now, the better you will be in the end. But just start with something. Try to start paying the interest on just one of your loans and then build up from there.
If you can start these habits of paying the interest now while you’re still in college, you’re going to be miles ahead when you finally get out.
So, if you had an extra $1,000 what would you do with it? Let me know in the comments below.
Clarification: I did want to mention that the calculations used in the last section are based on loans accruing interest using the simple interest formula discussed at the beginning. While the large majority of student loans use this, there are a few student loans out there who use compound interest. You should be sure and read the terms for your specific loan to find out how interest is calculated. If compound interest is used, the correct equation for your monthly interest amount would be (Principal*(e^(APR*years))) where e is the mathematical constant 2.71828…But for 90% plus of student loans, everything explained above is all you need.