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How Student Loan Interest is Calculated and Why it Varies from Month to Month

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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:

  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.

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.

When Does Compound Interest Kick-in?

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The day we begin investing money into interest bearing accounts we begin to earn interest on that money.  But for most of us the interest amounts earned on our savings can be pretty minute for quite a few years.  Oftentimes piddly interest amounts earned can discourage investors and savers alike causing many to fore go saving altogether, opting instead to use their discretionary income on the here and now.

To help us avoid this huge mistake, let’s spend some time studying the meaning and payoff schedules of compound interest.

Kick-in = when we start seeing our yearly interest payments supersede our savings contributions themselves.

If we contribute to our savings regularly, when will compound interest finally “kick-in?”

Let’s take a look…

Compound interest explained

Compounding – The ability of an asset to generate earnings, which are then reinvested in order to generate their own earnings. In other words, compounding refers to generating earnings from previous earnings.  Also known as “compound interest”.  source: Investopedia

Compound Interest – Interest that accrues on the initial principal and the accumulated interest of a principal deposit, loan or debt. Compounding of interest allows a principal amount to grow at a faster rate than simple interest, which is calculated as a percentage of only the principal amount.  source: Investopedia

Example: We have an annual salary of $50,000/year and save 12% of our pay.  At the end of the year we have $6,000, which earns us a 7.5% return in our retirement account leaving us $6,450.  If we continue to invest this money we earn interest not only on our original $6,000 but also on the $450 gained in interest on the original principal.

Why we should care

It can work for us…

Through the rough numerical examples above we are able to see how compound interest can be a very powerful savings tool that stands to benefit us more the longer we employ it.  That is why you always hear people saying to invest as early in life as possible.  The sooner we get compound interest working in our favor, the sooner we can live employment optional (my term for working when you want.)

Or it can work against us…

Anyone who has a mortgage is all to familiar with what I am about to say.  Let’s say your purchase a home for $150,000 with $0 down and finance it for 30 years at 5%.  You will have monthly payments of $805.23, with the majority going toward interest all the way until year 16 when your principal payments will begin to be larger than your interest payments.  When it’s all said and done, you will pay $139,883.68 in interest and your $150,000 house will end up costing you $289,883.68.

When does it pay off?

If we continue to save regularly, when will the yearly interest on our savings begin to supersede our savings contributions themselves?

The answer to that question is always going to be relative to how much we are earning and how much we are saving, but should generally conform to the secret of two times pay.

The Secret of Two Times Pay is a concept I recently came across while reading Your Money Ratios.  Author Charles Ferrell says that, “our finances hit a tipping point at about two times pay.” Charles goes on to say, “After you have saved two times your pay, the earnings from your capital will generally add more to your total wealth than the amount you save each year.”

Let’s consider our example from above once more:

Let’s assume we have been saving for 10 years and have $100,000 saved in our retirement account, or twice our annual pay.  With our 7.5% return the earnings on our $100,000 will be $7,500 which now exceeds our annual savings amount of $6,000.  This year we increase our retirement savings by $13,500 and more than half of it came from earnings on our capital.

How long will it take?

That all depends on you!

Don’t forget about the ‘Rule of 72’

The ‘Rule of 72’ – is a simplified way to determine how long an investment will take to double, given a fixed annual rate of interest. By dividing 72 by the annual rate of return, investors can get a rough estimate of how many years it will take for the initial investment to duplicate itself.  source:  Investopedia

Example: a 10% investment will take 7.3 years to double ((1.10^7.3 = 2).

Set a goal to save twice your annual income so you can begin watching your money work harder for you than you do!  This is a goal that is attainable with just a few years of disciplined, consistent saving.  Let’s use this as further motivation to stay on track.

All I know is the sooner we get out of debt and get started investing, the sooner we will be able to watch our capital work for us instead of us working for our capital!

Understanding and Improving Cash Flow

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One of the more powerful concepts to understand in the matter of personal finance is cash flow. Most of us can easily tell the difference between being confident & comfortable with our finances versus struggling with our finances.  Unfortunately, many people do not truly understand cash flow, nor do they grasp the crucial role it plays in regard to their own personal finances. When you understand the concept of cash flow and can then work to improve it… you give yourself tremendous flexibility which will undoubtedly bring to light many otherwise indiscernible opportunities.

What is cash flow?

Cash flow is basically your income minus your expenses. If your income is about the same as your expenses, you’re living paycheck-to-paycheck. If your income is higher, you’re financially okay. And if your income is lower, you’re accumulating debt. Very simple isn’t it?

And here is the beautiful part. Once you understand the basic components — income and expenses — you can begin to take concrete actions to improve your finances. And you can break down the problem even further by looking at reducing individual expenses and improving your income.

How to improve your cash flow

Reduce your expenses

The quickest way to improve your cash flow is by attacking your expenses; especially the recurring month-to-month type. The biggest bang for your buck is your mortgage, if you have one. Take a look at today’s best mortgage rates and see if it makes sense for you to refinance. Refinancing alone could free up several hundred dollars that you could use for other financial endeavors.

This process of expense reduction is even easier if you are already keeping a budget. If you don’t have one, you should start tracking your expenses and start work to create one. The key to success in expense reduction is doing all the little things that add up and trying to take one small step at a time. Don’t try to reduce your expenses by 50% — it will never happen. Challenge yourself to cut $50 a month or a $100 a month. Once you accomplish that, go for another $50, and so forth.

Increase your income

The other side of the equation is improving your income. This is harder than cutting your expenses, but there are things that you could do — even little things like moving your money to a high interest savings account helps you to earn more. Again, it’s all the little things that add up.

What about a other income ideas? You can basically break them down into a few categories:

  1. Earn more from your job — i.e., ask for a raise, get a promotion, work overtime, etc.
  2. Earn more outside your job. Here are a few additional income ideas for you to mull over.
  3. Make your money work harder — i.e., investing in the stock market, real estate investing, and other alternative investments, etc.

What to do with your free cash

So you’ve improved your cash flow, what should you do with the extra cash? Here are a few ideas:

  • Pay down your debt — e.g., credit card debt reduction, car loan, student loan, etc. As you do this, you’ll free up even more cash because you no longer have to pay all the finance charges and monthly payments.
  • Invest your money. Again, make your money work for you and continue to improve your cash flow.
  • Give. If you are in a position to give, charitable donation is also a great way to use your money.

I hope you enjoyed this article, and more importantly, I hope you walk away with a few ideas you can use to improve your finances.

Pinyo is the owner and primary author of Moolanomy Personal Finance blog. Moolanomy focuses on practical money management concepts, personal finance tips, and wealth building. If you like this article, please visit his blog. Lastly, you can leave financial question on Moolanomy Answers where Pinyo and other community members participate to provide you with answers.