Understanding Interest

Interest is the cost of borrowing money. It begins to accrue, or add up when loan disbursements are made or credit is issued. Be it interest earned on a personal savings or checking account or interest accruing on federal student loans, private student loans, personal loans, or credit cards, it's important for students to understand interest, how it affects them, and how to stay on top of it. The following are some tips you can offer students on how to use credit in the most advantageous way.

What Do the Terms Mean?

Understanding the definitions of common interest-related terms is important. The most commonly used terms are principal, interest rate, and capitalization.

  • Principal: The actual amount of money borrowed.
  • Interest Rate: The amount charged by a lender to a borrower for the use of assets, expressed as a percentage of the principal.
  • Capitalization: Any unpaid interest added to the principal. Unpaid interest is often interest that accrues during times when payments are postponed, (e.g., grace periods, forbearances, or deferments). Capitalization of interest can occur at the time a loan enters repayment for the first time or after a temporary suspension of payments.

How Does it All Work?

The amount of interest that will be paid depends on:

  • The amount of money borrowed (i.e., the principal).
  • The rate at which interest is charged (i.e., the interest rate).
  • Whether the government pays the interest during periods of in-school enrollment or deferment.
  • The length of time taken to repay the loan.

How to Reduce Interest Paid

There are ways to reduce the amount of interest to be repaid.

  • Make payments when not required (e.g., during in-school, deferment, or periods that postpone payments). Doing this can avoid interest capitalization, which reduces the overall amount to be repaid.
  • Enroll in Auto Pay, which often times reduces the interest rate charged.
  • Pay more than the minimum monthly payment. Doing this may cover the accrued interest amount, and directly reduce the principal balance.

How to Calculate Interest

The amount of interest that accrues (accumulates) on loans from month to month is determined by a simple daily interest formula. This formula consists of multiplying the loan balance by the number of days since the last payment, times the interest rate factor.

Visit the Financial Student Aid (FSA) website to learn more about how interest is calculated.

Interest Rates

It's important to keep finances healthy for many reasons. Bad credit can have a negative effect on interest rates charged on loans and/or credit cards. For example, if a lender checks a potential borrower's credit report and finds the borrower has a record of missing payments, that lender may decide to deny credit for the customer or charge a higher interest rate for the loan than they would for a customer who has a clean credit report. A credit history in good shape can save money by allowing borrowing at lower interest rates.

How to Stay on Top of Interest

The best ways to keep interest charges from getting out of control are to:

  • Keep overall healthy finances reflected in credit ratings to ensure interest rates on loans and/or credit cards will be low.
  • Pay more than just minimum payments each month so those payments go toward the principal of a loan and not just the interest every month.