Friday, February 18, 2011

How Is Student Loan Interest Calculated?


Most student loans (including all federally guaranteed loans) use a method of interest accrual known as the Simplified Daily Interest Formula. The difference between simple interest and compound interest (the type of interest that accrues on most major credit cards) is that simple interest is only calculated on the principal balance, not on the previously accrued interest – this is a good thing.

Simplified Daily Interest Formula

This is the formula used to calculate all federally guaranteed student loans:

  • Daily interest amount = (Current Principal Balance x Interest Rate) ÷ 365.25
  • Monthly interest amount = (Daily Interest Amount x number of days in the month)

Here is an example of daily interest calculated out on a student loan of $10,000 at a 6% interest rate:
  • Daily interest amount: (10,000 x .06) / 365.25 = $1.6427
  • Monthly interest amount: $1.64 x 30 (typical month) = $49.28

The above example shows us that a student loan with a balance of $10,000 and an interest rate of 6% would cost $49.28 in interest in a typical 30 day month.
Interest Rate Factor

Some student loan issuing agencies will make mention of something called the Interest Rate Factor. IRF is simply your interest rate divided by 365.25. If IRF is used in their calculation, rest assured that they are calculating interest the same… they just use a different equation to reach the same number. Here is the equation using the Interest Rate Factor:

  • Monthly interest amount = (Number of days since last payment) x (Principal Balance Outstanding) x (Interest Rate Factor)
Why does the amount fluctuate each month?

The answer lies in 2 conditional variables that effect the “number of days since last payment” from month to month:

1. How many days are in the current month
2. Did the last day of the calculation period fall on a weekend or holiday

The number of days since the last payment will obviously differ from month to month based on these two variables.

If the month has 28 days the interest calculated will be less than in a month that has 31 days because 3 extra days were figured into that months calculation. Also, if the last day of the month falls on a weekend or holiday, the calculation will not be performed until the next business day thus increasing that months number of days since last payment.

3 comments:

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