how interest works
Before getting a loan from a bank, a credit union, or some other lender, you must make an “interest agreement" with the lender. Through these agreements, you promise to pay back:
- the principal balance — the original amount you borrowed
- the interest — a fee that you pay the lender in exchange for borrowing the lender’s money Interest is calculated as an annual percentage rate of the amount you borrowed. For example, if you borrow $100 at 6.8% interest, at the end of the year, the interest you’ll owe on your loan will be $6.80. In this example, your estimated daily interest is around 2 cents per day ($6.80 divided by 365 days in a year).
Education loans accrue (accumulate) interest charges on a daily basis. With daily interest, you accrue one day’s worth of interest for each day you owe a balance to the lender. The higher your principal balance is, the greater your daily interest charge will be. The lower your principal balance is, the lower your daily interest charge will be.
Let's look at one of the most common loans that students use --- the unsubsidized Stafford loan. Here’s what your payments will look like if you repay your loan over 10 years with minimum monthly payments:You have a principal balance of $10,000 in unsubsidized Stafford loans. Your interest rate is 6.8%. Your payment will be about $115 each month (120 payments made over 10 years) Over 10 years, you’ll repay approximately $13,763:
- $10,000 of original principal
- $3,763 in interest
Avoid paying more for your loan.
- make late payments. You’ll pay more interest because you’re paying down your balance more slowly than was expected.
your principal balance will become $11,360, and your overall interest charges will increase. Depending on how much you borrow (and the amount of time, if any, during which you defer your interest payments), capitalized interest could cost you a substantial amount.
pay a bit extra with each payment.
Once you begin repaying your loan:
- each payment first goes toward paying the interest that has accumulated. The amount of interest taken from each payment depends on:
- the number of days between your payments
- the amount of principal that remains on your loan
- your interest rate
- the remainder of each payment goes toward reducing your principal.
Assuming you make regular payments on time, the principal balance decreases over time with each payment you make. When your principal balance reaches $0, you have successfully paid your loan in full.
If you pay even a little bit extra with each payment, you pay off your loan more quickly and help reduce your total estimated interest charges.
This is because you reduce your principal balance more quickly. This lowers the interest that is calculated, and thereby lowers the total cost of your loan.
There is never any penalty for prepayment (paying off your loan before your payment period is up).