Student Loans: The Basics on Interest Rates and Loan Fees

In Paying for College on Apr 13, 2016

Student loans aren't scholarships - it's important to understand what student loans are and how they work. Perhaps most importantly, it costs money to borrow for college and it's important to understand what this means.

Interest is an ongoing fee you pay for the use of someone else’s money. Interest is usually expressed as an annual percentage of the outstanding loan balance.

Interest rates may be fixed and unchanging over the life of the loan, or they may be variable, changing periodically (e.g., monthly). Variable interest rates are usually pegged to a variable index rate, such as the London Interbank Offered Rate (LIBOR), the Prime Lending Rate or the 10-Year Treasury Note, plus a fixed margin based on the type of loan and/or the borrower’s credit quality.

For example, federal student loans provide fixed interest rates. The interest rate on the Federal Stafford Loan was 4.29 percent for undergraduate students and 5.84 percent for graduate students for new loans in the 2015-2016 academic year. Each year’s new loans have a new interest rate that is fixed for the life of the loans. This is in contrast with a private student loan, which might offer a variable interest rate that is based on LIBOR + 3 percent, with the interest rate adjusted monthly.

Inexperienced borrowers are sometimes confused by interest rates. A common error is to think of interest as a one-time fee. Another common error is treating a variable interest rate as though it were a fixed interest rate, ignoring the index rate part of the variable rate formula.

For example, suppose you have a $10,000 loan with a 10 percent interest rate and a 10-year term. What is the total amount paid over the life of the loan? The first answer that comes to mind is $1,000, since 10 percent of $10,000 is $1,000. But, then you think some more and answer $11,000, since you also have to repay the amount borrowed. But, interest is charged each year based on the outstanding loan balance. The first year you might pay $972 in interest, slightly less than $1,000. But the second year you’ll pay $908, then $837, and so on, until you pay $83 in the last year. The interest paid each year averages slightly more than half of the interest paid during the first year, and there are 10 years, so total interest paid will be slightly more than $5,000. Add in the amount borrowed, and the total payments will be slightly more than $15,000. (The actual total payments is $15,858.)

In addition to charging interest, however, a loan may also charge one or more up-front fees, such as a default fee (to guarantee the loan against default) and an origination fee. For example, the Federal Stafford Loan charges a default fee of about 1 percent. This fee is deducted from the disbursement and is never paid before the borrower receives the loan.

(If someone asks you to pay a fee before you get a student loan, it may be a student loan scam called an advance-fee loan scam. Legitimate education lenders do not require borrowers to pay a fee before they receive the loan.)

Interest is charged while the student is in school and during the grace period before repayment begins. With certain types of loans, called subsidized loans, the federal government pays the interest during the in-school and grace periods. All other loans are unsubsidized. On an unsubsidized loan, the borrower remains responsible for paying the interest as it accrues (accumulates). If the borrower chooses to defer paying the interest, it will be added to the loan balance, causing the loan balance to grow bigger. Adding the interest to the loan balance is called interest capitalization. Interest capitalization will also cause interest to be charged on interest, yielding a more expensive loan.

(Need help understanding some of the terms in this article? Check out our student loan glossary.)

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