This Is How Student Loan Interest Works

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Student loans are a heavy financial burden for most borrowers, but the loan balance isn't the only major financial blow; the interest that accumulates is also difficult to stay on top of.

Interest on a student loan is a major contributor to how big your monthly payment will be and how much your loan will really cost by the time you pay it off. Let's look at how student loan interest works and what you can do to get your loans paid off faster and for less money.

Factors that determine interest on your student loan

There are a few factors that determine how much you will pay in interest on your student loan: the interest rate, the amount you borrow, the loan term, and your payment plan.

Interest rate

When you take out a student loan, you'll need to pay back the amount you borrow, plus interest on the loan. Interest is charged as a percentage of the amount you owe. For example, a $10,000 loan at a 10 percent annual interest rate (compounded daily) will cost you $1,049 after a year. So after one year, you would need to pay back the $10,000 that you borrowed, plus $1,049 for interest.

Amount borrowed

We have seen that a $10,000 loan at a 10 percent annual interest rate costs $1,049 in interest after a year. Of course, most student loans are much bigger than $10,000 — what if you borrow more? If you borrow $20,000, the interest cost to carry this loan for a year would be $2,097. If you borrow $50,000, the interest after a year would be $5,243. The more you borrow, the more interest the loan carries.

Loan term

The loan term is how long it will take you to pay back the loan. For example, you could borrow $50,000 and pay it back over 10 years. In this case, the term of the loan is 10 years. You can reduce your monthly payments by choosing a longer loan term, but you will end up paying more in interest.

If you borrow $50,000 at a 10 percent annual interest rate, you would pay $660.75 per month and your total cost for interest over the life of the loan would be $29,290.44. Now, let's say you want lower monthly payments, so you go with a 20-year term instead of 10 years. Your monthly payment would be $482.51, but over the life of the loan you would pay a whopping $65,802.60 in interest — about $35,000 more!

Payment plan

Student loans have more flexibility in their payment schedules than other installment loans. The simplest plan is to make the same monthly payments over the entire term of the loan. However, since new college grads typically have a lower income just after graduation and earn a higher salary over time, you can select repayment plans that start off with smaller monthly payments that increase as your income increases.

Variable repayment plans do make it easier to make payments on student loans, but the price to be paid for this flexibility is interest. Any payment plan that has smaller payments in the early years will cost more in interest over all. (See also: 6 Questions to Ask Before Taking Out Student Loans)

How much of your student loan payment goes to interest?

When you make your monthly student loan payment, at first, most of your payment will go toward paying interest. Only a small amount will go toward paying down the principal. Over time, eventually more of your payment will chip away at the principal until your loan is paid off in full.

Here's an example of how a payment of $660.75 per month on a $50,000 student loan at 10 percent interest would be applied to interest and principal during a 10-year term.

At first, you can see how the majority of the payment goes toward interest. But over time, as you continue to make payments, the balance of the loan decreases, thereby reducing the interest that accumulates and allowing more of your monthly payment to go to paying down the principal of the loan.

Most student loans give you the option to apply extra payments toward the principal. If you can pay a little extra each month, you'll bring your balance down faster and save money on interest payments over the life of your loan. For example, if you could pay $40 more per month, your loan would be paid off in nine years instead of 10, and your total interest cost would be about $3,000 less. (See also: What Really Happens When You Don't Pay Your Student Loans)

How to reduce your student loan interest

Once you understand how student loan interest works, you can put that knowledge to work. There are a few ways you can reduce the overall cost of your student loans.

• Paying your loan off faster will reduce the cost of interest. Choose the shortest term you can afford, and make extra payments if possible.

• Borrowing more will increase your interest cost. Try to minimize living expenses while in school to keep your student loan balance as low as possible.

Select the student loan option with the lowest interest rate available. If your rate is still higher than you'd like, consider refinancing your student loan later to a lower interest rate. (See also: 15 Ways to Pay Back Student Loans Faster)

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