It’s no secret student loan debt has become a trillion dollar problem for Americans. What’s worse is many people who took out student loans didn’t fully understand their interest rates when they signed the paperwork — myself included.
When I took out loans for school, I accepted the terms without question. I didn’t ask about student loan rates, shop around to compare federal interest rates with private lenders, or spend the time to learn how my interest rates would impact what I would owe in the future.
If you are in the same boat, read on to learn everything you need to know about interest rates on student loans and how they impact your balance.
What Are Student Loan Interest Rates?
When borrowing money to pay for college, lenders need something in return to make the deal beneficial for both parties. That’s where interest rates come in — your lender will charge an annual fee as a percentage of the amount you borrow. Interest charges are added to the principal balance and paid monthly.
The annual percentage rate (APR) on your loan will depend on a few factors and can even change over time, depending on what type of loan you have. Right now, it’s typical to pay a student loan interest rate of around 3%-6%.
How Student Loan Rates Are Determined
Federal student loan interest rates are set by the government and are tied closely to the 10 Year Treasury note, plus an additional percentage, according to U.S. News. Loan servicers are not able to set their own rates on federal student loans, and most loans have a fixed rate through the entire term (though some student loans offer a variable interest rate that can change yearly). New interest rates on student loans are set each spring before the new school year.
Private lenders, on the other hand, are able to determine their own student loan rates. Although base interest rates are set according to similar factors as federal student loans, private lenders also heavily consider your credit history when determining what you will pay. Private student loan rates can be fixed or variable.
Average Student Loan Interest Rate
Federal student loan interest rates for the 2015-2016 school year were announced this past May. Below is a look are current interest rates (note that Perkins loan rates are not included).
Federal Student Loan Interest Rates 2015-2016
Average Student Loan Interest Rates From Private Lenders
Because private lenders can set their own rates according to their own underwriting standards, the average student loan interest rate is based on a wide range. Private student loans tend to have higher interest rates than federal loans, with the industry average around 9%-12%.
Even so, the best private student loan servicers offer interest rates as low as 1.9% for borrowers with good credit.
How Student Loan Interest Rates Are Applied
Your student loan interest starts accruing the day you take out your loan. If you took out federal subsidized loans as a college student, the federal government paid your interest while you were in school and during your 6 month grace period. You become responsible for making payments toward the principal and interest the first day after your grace period ends.
If you took out unsubsidized or private loans as a college student, you accrued interest throughout your four years of college. It’s important to note that you must pay off any late fees and accrued interest first before any of your payments will be applied to your principle balance.
How Student Loan Interest Is Calculated
It’s important to know how to calculate the amount of interest your student loan debt accrues every day. Usually, this information makes borrowers extremely motivated to pay back their student loans quickly!
The formula works like this:
Interest Rate x Current Principal Balance ÷ Number of Days in the Year = Daily Interest
For a couple of examples, I will show the calculation for daily interest accrued on my husband’s medical school loans and my student loans, too.
Let’s start with my student loans, which are consolidated federal student loans. My current balance is $32,037 and my interest rate is 6.38%. Plug these numbers into the same formula and you get this:
.0638 x $32,037 ÷ 365 = $5.60 per day
My husband’s federal graduate and medical school loans currently total $377,654 with an average interest rate of 6.75%. If I plug these numbers into the formula above, I get this:
.0675 x $377,654 ÷ 365 = $68.84 per day (ouch!)
Yes, that means every day, my husband adds almost $70 in interest to what he will have to pay back in the future.
Clearly, my daily interest is a bit better than the interest my husband is accruing each day, but it’s definitely a good incentive for me pay back my student loans quickly and skip that Starbucks coffee knowing I already started the day more than $5 behind.
How to Reduce the Interest You Pay on Your Student Loans
There are ways to reduce the amount of interest you pay over the life of your loans. The best way is to pay off your loans as quickly as possible. Since interest accrues every day, the faster you pay off your debt, the less interest will accumulate.
If you have particularly high interest rates on your federal loans, you can also consolidate them into a private loan at a lower interest rate. This can save you thousands of dollars over the life of your loan.
Ultimately, the faster you pay off your loans the better. Now that you understand how interest is calculated and added to your bill, you’re hopefully more inclined to see it go sooner rather than later (I know I am!).