Student loan interest is calculated using either simple interest or compound interest. Here’s a breakdown of the two methods:
Simple Interest: Based on Principal Amount
Simple interest calculates interest charges based only on the principal amount. To compute monthly simple interest, multiply three factors: the daily interest rate, the principal (loan balance), and the number of days between payments.
The simple interest formula charges interest only on the principal, so the daily interest cost remains consistent throughout the payment period. For example, if your interest cost is $3 a day with a monthly billing cycle, your monthly interest is $90.
Each month’s payment covers the full interest amount owed for that month.
Compound interest: Paying interest on interest
With compound-interest loans, you’re always paying interest on your interest. In other words, the daily interest rate is applied to the current loan amount plus any unpaid interest up to that moment. If your loan compounds interest daily, each day’s unpaid interest is added to your principal balance.
For example, suppose your loan’s principal balance is $10,000, and the daily interest cost is $3.
On the first day, your interest cost is $3, and your loan balance becomes $10,003.
On the second day, interest is calculated on the new balance, resulting in a slightly higher daily interest cost.
This process continues throughout the loan repayment period, causing the interest cost to increase over time as the unpaid interest is added to the principal balance.