How to Manage the Long-Term Effects of Accumulated Student Loan Interest

Have you ever wondered why your total student loan balance seems to be going up, even as you’re in school or already making payments under specific plans? If so, you’re not alone.

A 2024 report from the American Bar Association’s Young Lawyers Division and AccessLex Institute titled “Student Debt, COVID-19 Relief, and Loan Forgiveness: Perspectives from Today’s Young Lawyers” found that 70 percent of law students knew their loan balance each year, but only 42 percent understood the interest and fees involved. This knowledge gap is larger among first-generation and minority students.

Whether you’re borrowing for law school, just graduated, or practicing law, understanding student loan interest is crucial. It aids in making informed borrowing and repayment decisions, especially with changing income-driven repayment plans for federal loans.

Simple vs. Compound Interest

Federal student loans have distinct features, especially regarding how interest is paid and accrued. Knowing the basics of simple and compound interest can help clarify how these loans work under various repayment plans.

Simple Interest

This is interest calculated only on the loan amount you borrowed or the amount currently outstanding in each cycle. For example, if you have a $30,000 loan at seven percent interest, you’ll pay about $1,935 in interest the first year. As you pay down the loan, your interest payments decrease because they’re based on the remaining principal balance each month.

Compound Interest

This is calculated on the outstanding loan amount you borrowed plus any unpaid interest. For example, if you have $10,000 in credit card debt at 16 percent interest, the interest for the first month is about $131.78. The next month, you’ll pay interest on $10,131.78, and your balance keeps growing if you don’t pay it off.

How Student Loan Interest Works

Private student loans work just like any other amortized loan, which has a fixed payment schedule. Part of each payment pays the interest due, and the remaining amount starts chipping away at the principal. Federal student loans, however, can have different rules.

During School

Unsubsidized federal student loans start accruing interest as soon as they’re disbursed to the student, even though you’re not making payments while in school. For example, a $20,500 Direct Unsubsidized Loan accrues about $4.54 in interest each day.

At Graduation

The interest that builds up (accrues) while you’re in school gets added to your loan balance when you graduate. This adding process is called capitalization, which makes your outstanding principal loan balance bigger. Moving forward, you’ll end up accruing interest on that new, larger balance.

Entering Repayment

After graduation, you get a six-month grace period where interest continues to accrue. After this, you start making payments. There are two main types of repayment plans: balance-driven (amortized) plans, which set fixed payments based on your balance and interest rates spread over 10 or 25 years, and income-driven repayment (IDR) plans, which set your payments based on the income you report to your loan servicer each year.

Income-Driven Repayment Plans: A Double-Edged Sword

Only available for federal loans, income-driven repayment plans* are designed to make your monthly payments more manageable by setting them at a percentage of your discretionary income (calculated by your loan servicer). However, they can also lead to more interest accruing over time because your payments might not cover all the interest that accrues each month. This ballooning of your overall balance is called negative amortization.

In fact, according to the previously mentioned report, about a quarter (27 percent) of respondents have a current student loan balance that is higher now than when they graduated. Of those, 71 percent indicate their balance has grown because they are on an income-driven repayment plan, and their monthly payments do not cover the principal.

Negative amortization is particularly concerning for borrowers employed by private firms or employers with more modest starting salaries. These individuals do not have the option of Public Service Loan Forgiveness after 10 years and may struggle to afford standard payments, let alone accelerate them, compared to their counterparts who begin their careers in Biglaw.

Tips to Manage Interest

Here are some strategies to help you manage your student loan interest:

• Make Extra Payments: If you can, put extra money towards your loan. Even small amounts can reduce your principal balance and the interest you pay over time.
• Pay Interest During School: If possible, pay the interest on your loans while you’re still in school. This prevents it from being added to your principal balance at graduation.
• Choose the Right Repayment Plan: Look at all the available repayment plans and choose one that fits your financial situation and minimizes interest.
• Stay Informed: Keep track of your loan statements and any changes to interest rates or repayment options. Being informed helps you make better decisions.
• Plan for the “Tax Bomb”: Under the current system, but potentially subject to continuing litigation, income-driven repayment plans forgive your remaining balance after 20–25 years. The catch is that the amount discharged is taxable, so it is important to plan and save for it if it’s a potential part of your long-term plan.              

The Importance of Financial Education

Accruing interest can significantly affect your student loan debt, especially if you are on an income-driven repayment plan. By understanding the mechanics of interest and taking proactive measures to manage it, you can mitigate its financial impact.

Remember, knowledge can bring peace of mind. Stay informed, be proactive, and seek out resources and assistance when needed. Use available student loan calculators and financial coaching resources to view your options and discuss your strategy with an Accredited Financial Counselor®.