Do Student Loans Have Compound or Simple Interest?

If you take out student loans to pay for school, you’ll pay interest on what you borrow. This is true whether you opt for federal or private student loans for college. Your interest rate is expressed as a percentage, and lenders charge interest for the privilege of borrowing money. 

Understanding how interest works on student loans can help you stay on top of your monthly payments. Here’s what to know about interest rates on federal and private loans, how they work, and what you can do to keep interest costs manageable.

Does student loan interest compound?

Lenders use two common formulas to calculate a borrower’s student loan interest: compound and simple interest. 

With compound interest, you pay interest on your principal balance and accrued interest charges on your loan. Compound interest typically results in higher payments than simple interest because you’re essentially paying interest on accrued interest. 

Fortunately, most student loans use a simple interest formula rather than compound interest. Simple interest means you pay interest on your principal balance only, not on the accrued interest.

While most student loans assess simple interest, this isn’t the case with all types of loans. Reviewing your loan documents can help you understand if your lender uses simple or compound interest to calculate your monthly payments. 

Do student loans have compound or simple interest? 

Federal loans apply a simple interest formula in most cases, though your interest could be compounded during deferment or forbearance. Simple interest considers your daily interest rate, your loan’s principal balance, and the number of days in your statement cycle. 

So if you have an outstanding federal student loan balance of $25,000, a 5.5% rate, and a 20-year term, here’s how your lender would calculate your monthly interest payments. 

• Daily interest rate: 0.055 / 365 = 0.00015
• Daily interest payments: 0.00015 x 25,000 = $3.75
• Monthly interest payment in the first month: 3.75 x 30 = $112.50

Many private lenders also use the simple interest formula above to help determine your monthly interest costs. But in some cases, lenders may use a compound interest formula instead. 

The formula for calculating compound interest is more complex because your daily interest payments are added to your total loan balance. Let’s use our numbers above for simplicity’s sake. For the purposes of our example, we’ll assume our lender compounds interest daily.

If our daily rate is $3.75, a lender that uses compound interest would add that amount to our balance on day one of our statement cycle. Then, it would charge interest on the new balance, including your initial principal and interest. It would look something like this:

Day one: 

0.00015 x $25,000 = $3.75

$3.75 + $25,000 = $25,003.75

Day two:

0.00015 x $25,003.75 = $3.7506

$3.7506 + $25,003.75 = $25,007.5006

Day three:

0.00015 x $25,007.5006 = $3.7511

$3.7511 + $25,007.5006 = $25,011.25

While initially, there doesn’t appear to be a difference in your daily interest charges, that amount can significantly increase over time. 

With a 20-year term and a 5.5% rate, you’d pay around $27,500 in simple interest charges on your $25,000 loan. By contrast, you’d pay around $50,097 in compound interest on your $25,000 loan. 

Simple vs. compound interest

Here’s a comparison of simple vs. compound interest and how they differ. 

Here’s what each figure in the formulas represents:

• P = Principal
• R = Rate (as decimal)
• T = Term
• C = Compounding periods in a year

	Simple interest	Compound interest
How it’s applied	Principal balance only	Principal balance, plus daily interest
Formula	P X R X T = Simple interest	P ( 1 + R / C) ^ (C X T) = Compound interest
Loan cost over long term	Lower	Higher

Pros of simple interest in student loans

Typically, student loan borrowers will find simple interest to be more advantageous because it’s generally lower cost over time. Here’s a closer look at the pros/cons of simple vs. compound interest. 

Easy to calculate

Simple interest is very easy to calculate compared to compound interest. This is especially true if you have a fixed-rate student loan. It’s still easy to calculate with a variable rate loan, though you’ll need to account for any rate changes in your formula. 

Interest costs could be lower

Your total interest costs could also be lower over time, as you’re only paying interest on your principal balance and not your principal plus any accrued interest. 

Debt may be easier to repay

Your debt might be easier to repay because you only pay interest on your loan principal. As your loan principal balance decreases over time, so too do your interest costs.

Cons of compound interest in student loans

Difficult to calculate

As shown in our example above, compound interest can be more difficult to calculate than simple interest. Instead of determining a daily interest rate and applying that rate to your balance, you’ll need to account for total compounding periods in a given year. Lenders can compound interest daily, monthly, or annually. 

Interest costs could be higher

Your costs will likely be higher over time since you’re paying interest on both your principal balance and accrued interest.

Debt may be harder to repay

As your interest grows with compounding, your loan balance can grow and may become more difficult to repay.

Simple interest is better than compound interest because you’ll pay less over the life of the loan. If your loan has compound interest, consider refinancing to a simple-interest loan to save money.

Chloe Moore

CFP®

How to manage student loan interest

If you’re concerned about how student loan interest will impact your monthly payments, you can do a few things to help control your interest costs. 

Pay more than the minimum

One of the most impactful ways to control your student loan interest costs is to make more than minimum payments. For instance, you might pay interest and a portion of your principal while you’re still in school. This could help reduce your loan balance and save money over your repayment term. 

Enroll in an income-driven repayment (IDR) plan

Note that Standard repayment periods for federal student loans are 10 years, while IDR plan terms are 20-25 years. Opting for an IDR plan could reduce your monthly loan payments, but extending your term might actually increase the amount of interest you pay over time. 

Still, an IDR plan could be worth it if it makes your monthly student loan payments more affordable. There are currently four IDR plans available:

	Repayment term	Monthly payment amount
Saving on a Valuable Education (SAVE) plan	20 years for undergrad loans 25 years for graduate loans	10% of discretionary income
Pay As You Earn (PAYE) repayment plan	20 years	10% of discretionary income
Income-Based Repayment (IBR) plan	20 years	10% of discretionary income
Income-Contingent Repayment (ICR) plan	25 years	20% of discretionary income

Refinance

You might also consider refinancing to reduce your interest rate if you have private student loans. Lower rates aren’t always available, but it’s worth shopping around if you have high-rate loans from private lenders. 

Take advantage of discounts

Some private lenders also discount you if you enroll in autopay. For instance, you might get 0.25% off your rate if you take this step.

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