Confused about how your student loan interest is calculated? Check out the simple explanation below!
A Simple Explanation of
When I made my first $1,200 payment to my six figure student loan debt, I was shocked at how much interest I paid (over $900!). I worked so hard to make that $1,200 payment, and then poof!, $900 of interest disappeared to the loan company.
Each month I noticed that my payment was being allocated differently: the amount going to my principal balance and the amount going to interest always seemed to fluctuate. This was very confusing. Some months I paid $800 towards interest, other months $900, and one month, only $600. What gives?
First, I’m going to explain what interest is. Then I’ll show you the equation of how student loan interest is calculated. Finally, I’ll share with you three reasons why each month you may pay a different amount to principal and to interest (even though your total bill is the same).
What is interest?
When you borrow money from a loan company (when you take out a loan), you are required to pay back that loan AND pay the company interest. Interest is a fee that you agree to pay in exchange for the opportunity to borrow money. Interest is usually a percentage of your balance.
The principal of the loan is the amount you borrowed. This principal balance goes down as you pay off the loan. The interest you pay does NOT lower your principal balance.
How is student loan interest calculated?
Student loan interest is calculated daily. Every single day you are paying interest on your student loans.
The amount of your monthly payment that goes towards interest (instead of going towards lowering your principal balance) is calculated using the simple daily interest formula shown below.
Here is an example of how to use the equation to calculate your monthly interest payment:
In the example above, you pay $507.46 towards interest. If your monthly bill is $900, only $393.54 is going towards lowering your principal balance (the $507.46 of interest goes straight to the loan company).
Why is the amount of interest different each month?
Since there are three variables in the equation above, there are three reasons why your interest payment may fluctuate each month.
Reason #1: your current principal balance is different each month
Each month, part of your payment goes to principal and part goes to interest. The part that goes to principal, lowers your principal balance – that’s a good thing!
As your principal balance gets smaller and smaller each month, the amount you pay in interest also goes down.
Reason #2: the number of days since your last payment is different
The number of days since your last payment is also a variable that can impact how much interest you pay each month. Even if you pay your bill on the same day each month (i.e. February 14, March 14, April 14, etc.), some months have different numbers of days in them, so the amount you pay towards interest will differ slightly.
If you pay your bills after you receive a paycheck, or at a random time before it’s due, then the number of days in the equation above will change and so will your interest amount. This was the main reason why my interest amounts differed so much from month to month. Some months, I would pay my student loan bill right after I got paid. Other months I would pay my bill on the day it was due. This would mean that some months I would have as much as 50 days between payments (I would owe a ton to interest in this case), and some months I would have as few as 15 days between payments (I wouldn’t owe as much interest in this case).
Reason #3: you have a variable interest rate
Your loan either has a fixed interest rate or a variable interest rate. A fixed interest rate means that your interest rate will remain the same during the fixed rate period of the loan (which can be the life of the loan). A variable interest rate means that your interest rate can fluctuate/change over time. So, during your first month (or first year), your interest rate may be 5.6%, but then the next month (or year), it maybe be 6.7%. The lower the interest rate, the better (it means you have to pay less interest).
If you have a variable interest rate, this can cause the amount you pay in interest each month to be different.
In my particular situation, deep into the terms of my student loan contract (which I never read when I signed it), was a hidden statement: Four years after the loan takes effect, the interest rate will increase by 2%. Ah, that was a rude awakening! I saw a drastic increase in how much was going to interest (and how little was being applied to my principal). That gave me the extra push I needed to get rid of my debt ASAP.
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Does the amount you pay in interest differ drastically each month? Were you also shocked by how much you pay in interest?
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