How much debt costs
As you may know… I keep track of how much our debt costs each month – which is basically how much monthly interest we pay toward debt. Shortly after I began tracking these numbers I noticed the interest charged on our student loans varies quite a bit from month to month… so I set off to find out why.
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)
Let’s plug our example numbers into this equation (our example interest rate factor is .000164271047:)
- 30 x 10,000 x .000164271047 = $49.28
Notice that we received the same monthly interest amount regardless of whether we used the Interest Rate Factor or not… that is because the math is exactly the same, the equation is just structured differently.
Why does the amount fluctuate each month?
Between my student loan and my wife’s student loan we paid $277 in interest for January 2010. In December of 2009 we paid only $261 in interest and in November of 2009 it was $288. Our principal decreases every month, so what’s up with the large fluctuations and how could we have paid more in November of 2009 than in January of 2010 if the principal is less? Great question.
The answer lies in 2 conditional variables that effect the “number of days since last payment” from month to month:
- How many days are in the current month
- 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.
Thus… regardless of the fluctuation in monthly amounts we will never be charged anymore than 365.25 days worth of interest on our student loans in a given year.
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Matt,
I was fortunate enough to get my student loans consolidated at a very low fixed interest rate. However….debt is debt….and interest paid is money I’m not saving!
I recently changed my point of view on my student loan debt when I ran the numbers…I assumed that because it was a low interest rate I could take my time paying these off. However, I now realize a better course of action for me is to eliminate this burden as well.
The fact that the interest is only applied to the principle is the main reason I’ve been paying extra AND making sure the extra is applied first to the principle.
Sallie Mae gives you the daily amount of accruing interest on your loans. Seeing this amount tick up daily shows me how much of my payment is going to just interest alone. It’s frustrating when you make a payment and it takes 3-4 days for them to apply it and in the meantime the interest is keeps adding up…It feels like a race you’ll never win but I’ll just keep plodding away! Great explanation.
Thanks for breaking down the difference between “simple interest” and “compound interest.” I actually wondered why that was and now I will be able to explain that to others more clearly. Regardless, my student loan is my last form of debt outside of my house and I am pplanning on paying it off in May 2010, so I won’t have to worry about it much longer
Feels good doesn’t it?
As a result of the Health Care and Education Reconciliation Act, beginning July 1, 2010, federal student loans will no longer be made by private lenders under the Federal Family Education Loan (FFELSM) Program. Instead, all new federal student loans will come directly from the U.S. Department of Education under the Direct Loan Program.
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