April is financial literacy month and this blog kicks off our financial literacy blog series! In keeping with this spirit, I wanted to break down some common student loan terms so that students and parents can be better informed about the student loan choices they make.
The following are a few basic loan terms that are imperative to know when taking out a loan for the first time:
Principal – The total amount of the loan when you take it out. Interest accrues on this amount.
Origination fees – These are fees charged by the lender for the “creation” of the loan.
Interest – The amount charged for use of the loan money.
Capitalized interest – An amount of interest that is added to your principal. This means that if you have a loan of 10,000 with $100 in interest, once your interest is capitalized your loan principal becomes $10,100. It’s always best to avoid capitalizing interest because any interest that accrues after is going to be based on this new, higher principal balance, so you will end up paying more over time.
Federal vs. Private
It’s important to know the difference between federal and private loans so that you can keep track of who owns the loan. Knowing what loans you have from the beginning saves a lot of time and stress later. Here’s a brief explanation of each type:
Federal loans – Federal loans are what a student can receive based on their FAFSA and are federally funded loans. These include Perkins, Stafford, Graduate PLUS, and Parent PLUS. Of these, only the PLUS loans are based on credit.
Private loans – Private loans on the other hand are not awarded based on your FAFSA information and are supplementary funds that a family must apply for through a specific bank or lender.
Subsidized vs. Unsubsidized
These terms are applicable to the Federal Direct Stafford Loan. When a loan gets disbursed (the money is sent to your school) it begins to accrue interest. Most students choose to defer payments until after graduation, but interest still accrues during this time.
The difference between subsidized and unsubsidized loans is that the government subsidizes the interest on the former, so you do not have to pay any accrued interest on this loan for the time you are in school. Unsubsidized loans accrue interest during deferment, and it is then capitalized upon repayment.
APR vs. Interest Rate
The first thing to note about these two rates is that they are not the same. The basic interest rate, which is what many people use to judge a loan, is simply the amount being charged by your lender for use of the money. APR (Annual Percentage Rate) is similar, except that it includes more than just the interest. The APR not only takes the interest rate into account, but also any associated fees. This means it is the amount you will actually end up paying for a loan of $XXXX. While low interest rates are good, comparing the APRs of loans allows you to compare apples-to-apple and know which is actually the best deal.
Fixed vs. Variable Interest Rates
These are the two types of interest rates. Fixed rates remain steady over the life of the loan. Variable rates are based on an Index such as the LIBOR or PRIME which are world-wide interest rates set by the current market.
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