When you take out federal student loans, you’re borrowing money directly from the U.S. government to pay for school. But while the U.S. Department of Education isn’t your typical lender, you’ll still pay for the privilege of obtaining credit in the form of interest.
But how does student loan interest work, and how much will your student loans ultimately cost you? Here’s how to find out how much you really pay the government on a student loan.
How does student loan interest work?
As with many other types of debt, federal student loans carry both interest and fees, which combined make up the total cost of borrowing money. Student loan interest is represented in the form of an annual interest rate.
For example, for the 2020-2021 school year, here are the annual interest rates for the different types of federal student loans:
- Direct Loans for undergraduate students: 2.75%
- Direct Loans for graduate and professional students: 4.3%
- Direct PLUS Loans for parents and graduate and professional students: 5.3%
But while student loan interest rates are shown as an annual figure, interest actually accrues on your loans on a daily basis. So when you make your monthly payment, a portion of it goes toward the interest that’s accrued since your last payment, and the remainder goes toward paying down the loan balance.
How are student loan rates determined?
Federal student loan interest rates are determined by Congress on an annual basis. There are no exact details about how our legislators come to these rates, but they likely consider current market rates, economic conditions, and other factors.
For example, for the 2019-2020 school year, the rate for undergraduate loans was 4.53%, which is considerably higher than the current 2.75% rate.
The good news is that regardless of your credit situation and income, anyone who gets approved for a certain type of federal student loan gets the same interest rate. In contrast, if you borrow from a private lender, your rate will be based on your credit history, income, other debts, and a handful of other factors.
How much does a student loan cost?
In addition to your loan’s interest rate, you’ll also pay an upfront loan fee with federal student loans. For example, for Direct Loans, the loan fee through September 30, 2020, is 1.059%, and for Direct PLUS Loans, it’s 4.236%.
This fee is deducted from your loan disbursement, which means that if you borrow $10,000, you’re not actually getting the full amount.
Here are a few examples to get an idea of how much student loans can cost you.
Example 1: Paying on the standard repayment plan
Let’s say you borrow $10,000 in undergraduate student loans with a 1.059% loan fee, a 2.75% interest rate, and the standard 10-year repayment term.
The loans are subsidized, which means the federal government pays your interest while you remain in school and during your six-month grace period after you graduate, fall below half-time, or leave college for another reason.
In this scenario, you’ll pay an upfront fee of $105.90 (though interest will be based on the original $10,000 balance). If you make payments on time and avoid deferment and forbearance during your 10-year repayment term, you’ll end up paying $1,449 in interest.
Combine the fees and interest charges for a total cost of $1,554.90 — that’s over 15% of the initial loan amount over 10 years.
Example 2: Switching to an income-based repayment plan
In this scenario, let’s say you’re struggling to find a job right out of college, and you decide to put your $10,000 in student loans on an income-based repayment (IBR) plan. Calculating your interest with this and other income-driven repayment plans can be challenging because there are many other variables to consider.
But for the sake of simplicity, let’s say you currently earn $25,000 per year and expect your income to grow by 3% annually. Your monthly payment would be reduced from $95 to $58, but your repayment term will be extended to 25 years. Over this time, you’ll end up paying $2,144 in interest, which is roughly $700 more than you’d pay if you stayed on the 10-year plan.
Again, add that to the loan fee, and your total cost on this plan would be $2,249.90.
Example 3: Refinancing your student loan with a private lender
In some cases, refinancing your federal student loans after you graduate with a private lender could potentially save you money.
For example, let’s say you’re eligible for a 2.25% interest rate with a private lender – a lower rate currently attached to your federal loans by the government.
By refinancing and keeping the same 10-year period, your total interest charges over that timeframe amount to $1,176, a savings of almost $300.
You could also opt to refinance with a shorter or longer repayment term. With the former, you’d be able to pay off your debt faster and save even more on total interest accrued. On the flip side, extending the term could reduce your monthly payment and give you more wiggle room in your budget for other goals, but would ultimately cost you more in interest.
Just keep in mind that not everyone qualifies for student loan refinancing, and you may need a creditworthy cosigner to get approved for the best rates available.
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Lower your federal student loan rate through refinancing
Depending on your current interest rates, you may be able to reduce your interest rate and monthly payment with a student loan refinance company.
To start, check your credit to see where you stand. While it’s possible to get approved for refinancing with a score in the mid-600s, the better it is, the higher your chances are of scoring a low interest rate.
Also, consider your income — the average approved student loan refinance borrower has an average annual income of $98,156. Again, that’s not a minimum, but the higher your income, the better.
If your credit score and income aren’t quite where they need to be, consider asking someone to cosign on your loan.
Next, take some time to compare student loan refinancing interest rates so you can save the most money possible.
With Purefy’s Compare Rates tool, you can view rate offers from multiple lenders side by side. This can help speed up the process of shopping around and give you a better chance of getting the lowest rate available to you.
In the end, if you don’t qualify for a lower interest rate or if refinancing your student loans doesn’t help you achieve your financial goals, it may not be for you. But as you research student loan refinancing and other options, you’ll get a better idea of which path forward is the best for you.