Take 4 Steps to Understand Student Loan Interest Rates

Students can tamp down interest – and prevent it from capitalizing – by paying it down in school.

Megan Murray graduated from the University of Central Oklahoma in 2005 with a relatively reasonable $13,000 in undergraduate loan debt.

But after spending several years teaching in China – and deferring her loan payments – she came home to find that her high-interest private loans had swelled to around $30,000.

I didn't know that the second I'd cashed that check, interest started accruing, says Murray.

Murray buckled down, moved back in with her parents and managed to pay off her debt within several years.

And while her experience is extreme, the fact is that interest is a major – and often overlooked – cost of borrowing student loans.

Even ignoring interest while in school can cause it to escalate, says Scott Morrison, director of financial aid at Bridgewater College in Virginia.

It’ll depend on when the loan is taken out, says Morrison. But not paying interest on an unsubsidized loan or private loan can increase the loan balance by 10 percent to 20 percent.

Here are four steps to understanding your student loan interest.

1. Learn the interest on federal loans: Interest on federal student loans varies depending on several factors, including the type of loan, year it was borrowed and whether the borrower is an undergraduate or graduate student.

For college students borrowing in the 2014-2015 school year, subsidized loans. which have interest covered in school, and unsubsidized loans, which don't, carried a 4.66 percent interest rate.

For graduate students in 2014-2015, unsubsidized loans carried a 6.21 percent rate – higher than the rate for undergraduates. PLUS loans. available to graduate students and parents for up to the full cost of attendance minus any other aid, charged 7.21 percent.

Those rates are fixed over the life of the loan, meaning that once they're disbursed, they won't change. But the 2015-2016 school year will bring fresh market-based rates for new loans.

Perkins loans. available to both undergraduates and graduate students at certain schools, don't see interest rates vary the same way the previous loans do. They have interest fixed at 5 percent over the life of the loan.

Although credit doesn't affect the rate of a federal loan for individual borrowers, an adverse credit history can block borrowers from PLUS loans.

2. Investigate interest on private loans: Credit scores matter in the private loan industry, so families with strong financial histories can expect better rates while those with less-than-stellar credit reports may need to borrow at a higher rate or find a cosigner.

Interest may also depend on the repayment terms, whether the student signs up for automatic debits – which also nets borrowers an interest rate reduction on federal loans – and other factors.

Students often have the option between a variable-rate loan, which adjusts at regular intervals with the market, and a fixed-rate loan.

Right now Sallie Mae, for example, advertises variable rates between 2.25 percent and 9.37 percent on its Undergraduate Smart Option Student Loan. Fixed rates run from 5.74 percent to 11.85 percent.

While variable rates are lower right now, borrowers should be cautious when committing to one since they can rise over the life of the loan.

Students have to be careful when selecting a variable rate loan to make sure that it won't go up exponentially, says Dominic Yoia, associate vice president and university director of financial aid at Quinnipiac University.

Repaying the loan quickly can reduce the risk of seeing it skyrocket, he says.

3. Beware of capitalization: On many student loans, including many federal loans, any interest that accumulates during school and deferment is capitalized and added to the original balance of the loan. This can create a snowball effect, causing the amount owed to increase, with students paying interest on interest, and repaying more debt.

Students can tamp down that interest – and prevent it from capitalizing – by making interest-only payments while in school.

Being mindful of what they've borrowed and using a repayment calculator will also help students avoid sticker shock after graduation, says Joe DePaulo, CEO and co-founder of College Ave Student Loans, a private student loan provider.

I think that writing down and knowing what you owe is really important, he says. You know what your payment will be when you get out – and that what you borrowed is different than what you owe when you get out.