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How Does Student Loan Interest Work and Other FAQs

Regardless of whether you have existing debt you're trying to pay down or you’re considering going back to school, it's important to understand how student loan interest works.

Chris Scott

Contributing Writer at Tally

October 8, 2021

Student loan interest is a topic so complicated, it might as well have its own degree associated with it.

If you have existing student loan debt, or you’re thinking about becoming a borrower so you can go back to school, you may be wondering, "how does student loan interest work?”

To get to the bottom line of student loan interest, it can be helpful to learn how it affects your credit, how it can impact your future efforts to buy a home and the potential relief opportunities you have available as a borrower.

By the end of this piece, you should have a solid understanding of how student loan interest works. 

What are the basics of student loans? 

To better understand how interest rates work, it's important to understand the two primary types of student loans

  1. Federal student loans

  2. Private student loans 

Federal student loans are government-funded, while private student loans come from lenders such as: 

  • Banks

  • Credit unions

  • Colleges and universities 

  • State agencies 

Government-backed loans tend to have benefits that private student loans don't. These can include fixed interest rates and income-based repayment plans, meaning your student loan payments are based on how much you earn. 

Private student loans, on the other hand, have stricter terms and conditions. Private lenders can set their stipulations and aren’t bound by government restrictions. Though not always the case, private student loans tend to be more expensive than federal student loans. 

To secure a loan, you need to apply for financial aid. When you do, you’ll be offered student loan options. These will either be public loans, private loans or a combination of the two. These offers will include the: 

  • Loan term 

  • Loan amount 

  • Interest rate 

If you have a federal government loan, your interest rate is fixed. This means it cannot change during the life of the loan. 

If you have a private loan, you may have either a fixed or variable interest rate. If you have a variable interest rate, your rate can change. Oftentimes, you will have a lower interest rate at the beginning of the loan. 

When you agree to accept the loan, you sign a promissory note with your loan servicer. This note spells out your student loan interest rate as well as other terms and conditions. It includes your repayment plan, late charges or penalty fees and explanations about defaulting consolidation and loan forbearance. 

How does student loan interest work? 

Student loan interest rates compound. This means that when interest is charged, it’s added to your balance. Your next interest charge is based on the previous balance. Compound interest charges can add up quickly, especially if you fall behind on payments. 

Your promissory note will spell out how often your interest compounds. If you have a daily interest rate, your lender will determine how much you owe by taking your interest rate and dividing it by the number of days in a year (365). This means that each day, interest is added to your principal balance. 

If you have a monthly interest rate, your loan provider will figure out your interest payment by taking your interest rate and dividing it by 12 (since there are 12 months in a year). And, if you have an annual interest rate, your loan provider will apply your interest rate to your balance once per year. 

It's important to note that accrued interest starts the day the loan is disbursed to your school. You may have a grace period during which interest is not added to your balance, but your unpaid interest will capitalize at the end of the grace period. With capitalization, the total amount of interest that's unpaid will be added to your current loan balance. From there on out, your interest will be calculated based on the new balance. 

Repaying student loans can be challenging. Some private loans begin charging interest and requiring repayment while you’re still in school. Other public loans may not require repayment until graduation when you’ll hopefully have some income to help with the payments. But, unless there’s a strong financial need, it’s wise to look for assistance from alternative options like scholarships and grants. 

Lastly, it's important to know the type of loan you’re getting to understand how it will impact interest. For instance, one type of public loan is a direct subsidized loan. If you have one of these loans, the Department of Education will pay the interest if you’re in school at least half time, as well as during your six-month grace period. The type of loan you have can impact the interest, so reading the fine print before signing on is important. 

How does student loan interest affect credit? 

When it comes to your credit history, student loans are similar to other loans and borrowed funds. If you make monthly payments on time and in full, student loans can positively impact your credit. But if you start to miss payments, student loans will negatively impact your credit score

Either way, having a student loan allows you to establish a credit mix. Lenders like to see credit from a few different sources, and without student loans, your only source of credit could be a personal loan or credit card

If you miss a payment on a federal student loan, you have 90 days to catch up and pay it back. If you do, the missed payment won’t be reported to the credit bureaus. If you don’t make a payment for 90 days, however, your loan will go into default. This can have a considerably negative impact on your credit. 

The grace period is often the same if you have a private loan, but it could be less depending on your lender. 


How does student loan interest impact buying a home? 

When buying a home, lenders often look at your debt-to-income (DTI) ratio. If you want to receive a qualified mortgage, your DTI ratio needs to be less than 43%. If you have a high student loan balance, your DTI may be over this threshold. 

However, the Federal Housing Administration (FHA) recently made it easier for people with student loans to secure a mortgage. An FHA loan is available for as little as 3.5% money down. They are also available for those with credit scores as low as 580 without a cosigner. 

Are there student loan relief opportunities available? 

If you’ve fallen behind on your student loan payments, there are some relief opportunities available. Consider these options: 

  • Public service loan forgiveness: This option is for government employees or those employed by nonprofits. It becomes available after you’ve made 120 qualifying monthly payments while working full-time for a qualifying employer. 

  • Teacher loan forgiveness: If you teach at a low-income school for five consecutive years, you could have up to $17,500 of your student loan forgiven.

  • Borrower defense to repayment: If you took out the loan for professional studies and believe the school committed misconduct, you could be eligible for loan forgiveness

  • Other relief opportunities: You may also be eligible for loan forgiveness if you've become totally and permanently disabled, are eligible for bankruptcy, didn't complete your studies or qualify for additional student loan forgiveness opportunities.

Additionally, the federal government has considered going one step further to offer protections to borrowers by waiving a substantial amount of student loan debt. 

Keep working to improve your personal financial situation 

Regardless of whether you’re trying to make the last payment on your existing loan or you’re looking to enroll as a graduate student, it's important to understand how student loans work. Before signing a promissory note, it’s smart to fully weigh your repayment options and understand exactly what it is you're signing onto. 

Student loans can play a significant role in your future lending options. Missing payments can impact your credit score. And if you carry a high balance, your DTI may be too high to meet the 43% threshold required for a qualified mortgage. 

If you’re balancing student loans on top of credit card debt, consider Tally†. Tally is a credit card debt repayment tool that can help you eliminate credit card debt faster with a lower-interest line of credit. 

To get the benefits of a Tally line of credit, you must qualify for and accept a Tally line of credit. The APR (which is the same as your interest rate) will be between 7.90% and 29.99% per year and will be based on your credit history. The APR will vary with the market based on the Prime Rate. Annual fees range from $0 - $300.