How is my federal student loan interest calculated? What happens if I miss a payment?

Interest on your federal student loans is adding up again this month. But what is it? And how does interest affect your payment?

Let’s break it down.

Federal student loan payments leave forbearance in October for the approximately 43.4 million borrowers with $1.63 trillion in outstanding debt, according to the office of Federal Student Aid. As of Sept. 1, interest started accruing on these loans again.

“It’s definitely a big shock for a lot of people because we’re going from a period when interest was paused to suddenly starting to accumulate again,” said Kimberly Palmer, personal finance expert with NerdWallet, told McClatchy.

There is a grace period. The Education Department is implementing a 12-month “on-ramp” to ensure borrowers who miss payments won’t be considered delinquent, reported to credit bureaus, placed in default or sent to a debt collection agency.

Regardless of if borrowers make payments, interest will still accrue.

What is interest?

In terms of debt, interest is how much a lender charges you to be able to borrow money from them, according to Investopedia.

With investments on the other hand, interest can benefit you in situations such as when you put money in a high-yield savings account and earn interest — essentially free money — on your savings.

How is interest decided?

Interest rates for federal student loans vary depending on the loan type and when you take it out, according to the office of Federal Student Aid.

Federal student loan interest rates are the highest they’ve been in a decade. While those rates are not tied directly to the federal funds rate set by the Federal Reserve, the Fed’s decision to raise interest rates — to the highest level in 22 years in August — means borrowing costs get more expensive. The Fed’s decisions generally influence other interest rates.

NerdWallet reported federal student loan rates — which are set by federal law — follow a formula based on the 10-year Treasury note.

Federal student loans have fixed interest rates that are set on July 1 every year. For this school year, new direct federal loans for undergrads will have an interest of 5.5%, up from 4.99%. Graduate students will have a 7.05% interest rate and those taking out PLUS loans will be at 8.05%.

“The first step is just getting your head around it to understand exactly what’s happening and how the money that you owe is going to grow over time as interest accumulates,” Palmer said.

To do that, borrowers should log into their StudentAid.Gov accounts. Palmer also recommended using online calculators such as NerdWallet’s student loan payoff calculator to see how extra payments could save them money on interest.

Extra payments — which borrowers can ensure go to their principal by checking with their loan servicer — reduce how much interest they pay in the long run. Using a tax refund, for example, to make an extra payment on your student loan can speed up the payoff process.

How does interest add up?

Direct loans issued by the education department are a type of daily interest loan, meaning interest adds up every day.

If you have unpaid interest, none of the money you pay will go to your principal until that interest is paid.

And then there’s the difference between subsidized loans and unsubsidized.

Subsidized loans: This means the government pays the interest while you’re in school at least half-time, during a 6-month grace period after leaving school, and if you defer your loans.

Unsubsidized loans: This means that even while you’re in school, you’re responsible for the accruing interest.

Note: Eligible loans paused during the pandemic forbearance period had interest rates set to 0% from March 2020 to August 2023. You don’t owe interest for the elapsed time.

How is interest calculated?

Here’s the formula for daily interest, according to the office of Federal Student Aid.

Interest amount = (outstanding principal balance X interest rate factor) X number of days since last payment

You can calculate your interest rate factor — how much interest accrues on your loan — by dividing your loan’s interest rate by the number of days in the year.

An interest example

If you took out a $10,000 direct unsubsidized loan at 6.8%, your daily interest would be $1.86.

After you graduate, you have a 6-month grace period. But because it’s unsubsidized, your loan still accrues interest. If you don’t make payments, at the end of the deferment you’ll have accrued $340 in interest that will be added to your principal.

That makes your principal balance $10,340.

That means your new daily interest is $1.93.

And that means you’ll end up paying more over time.

When does interest get added to your outstanding debt?

When unpaid interest capitalizes, that means it’s added to your principal balance.

Your interest is then recalculated based on that higher number, which increases how much your loan costs. And it could also increase your monthly payment, depending on your plan.

For traditional repayment plans (including standard, graduated or extended), monthly payments include the interest that’s adding up, meaning no extra interest will accrue and it won’t add to your principal, according to the office of Federal Student Aid.

However, on some income-driven repayment plans — if your monthly payment is less than how much interest accrues, which is called negative amortization — or if you’re not making payments, interest can add up.

That’s not the case with the new income-driven repayment plan: Saving on a Valuable Education. President Joe Biden’s administration calls it the “most affordable payment plan ever created.” If you apply for that, your loan balance won’t grow because of unpaid interest as long as you keep up with payments.

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