Interest on a student loan is calculated daily using the simple interest formula. When borrowers hear that interest accrues every single day it makes them believe it may be the worst for their bottom line when in reality it is the best. When an account accrues interest daily there is no such thing as prepaid interest. This is why when you make extra payments to your student loans you don’t mark them as “principal only” similar to what you do with a mortgage payment.
In addition, with the exception of when interest capitalizes (added to prinicpal), you will never end up paying interest on interest. This is the reason why the principal and interest accrue separately.
So we have been over it before but here is the formula and a few examples.
You take the principal balance of a loan
You multiply that balance by the interest rate. This gives you the yearly amount of interest you would pay.
To get the daily interest you divide this number by 365.
So lets take an example. You have $20,000.00 in loans at 5.5% interest. So to figure out the daily interest just place it into the above formula.
$20,000 (principal) x .055 (interest rate converted to decimal)
=$1100 (yearly interest total) /365 days
=$3.13 daily interest
This means that if you pay your bill on a 31-day cycle your interest for that billing cycle is $93.42 if you pay the next bill 28 days after the first one $84.38 will have accrued between cycles and if you pay your bill 34 days in between bills your daily interest will be $106.42.
But what happens once the payment is made? Will the interest always be $3.13? Not at all! Let us take the 31 days example where your interest accrued is $93.42. On this total you pay $500.00. For student loan payment application (with one exception), you pay the interest first the rest goes to principal.
So in our example $93.42 is going to interest while $406.58 goes to principal . This reduces the principal down to $19,593.42. Once the principal changes then daily interest is recalculated.
So let’s do the equation again.
$19,593.42 x .055
=$2.95 (new daily interest)
Then for future payments since your daily interest drops less will go to interest and more will go to principal. This is why your payment is primarily interest at the beginning but at the end it works to primarily principal.
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